June 17, 2024

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Designing Homes With Heart

How to Understand Mutual Fund Cost of Ownership

The purchase of my first car in 1981 was a great learning experience. After signing on the dotted line, and agreeing on what I thought was the final price, I was sent to the finance manager only to learn that the price I negotiated was not the final cost. I learned I had to pay extra for the floor mats, some made up fee called dealer prep, rust under-coat, and a few other charges that added nearly $500 to the cost of my $6100 car. I began to realize that what I didn’t know could hurt me or worse, what I thought I knew to be true… wasn’t. Maybe you feel the same way about your investments. One potential termite in the 2 x 4 of your investment portfolio could be the fees and commissions you are paying to purchase your mutual fund, real estate investment trust (REIT), Variable Annuity, or other product commonly offered through brokers.

This article will focus primarily on mutual funds and the cost of ownership and what questions you can ask your financial advisor to try and ensure that you are not exposed to some charges that may be avoid-able.

According to the Wall Street Journal1, fees have a tremendous impact on your realized returns. Here are a few of the ways mutual fund companies reduce your investment return through fees, loads, trading costs, platform fees, taxes, marketing costs called 12 -b1 fees, bid-ask spreads, and market impact cost. Although mutual fund companies are required to disclose the last three years of trading costs and the prospectus, it is difficult in some cases to determine what the actual cost is as an annual percentage value.

Here are a few of the pesky charges that can be avoided or managed.

1. Buying A shares-this type of mutual fund has the letter “A” in the fund name. It means there is a front end commission paid out of your initial investment to the broker. It can run as high as 5.75{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df}. 2

Some mutual fund families give you a pricing break if you put enough money into their family of funds. Ask your broker if you can receive a discount by investing more with the same mutual fund family. Generally A share mutual funds are better suited for investors who plan on making fewer portfolio changes and who want to stay in the same mutual fund for 11 to 15 years. If you don’t believe you will stay in the mutual fund that long, maybe you should consider purchasing “C” share mutual funds. They generally have a higher management fee, but you can change to different mutual funds without having to pay another upfront commission to the broker if you should change your mind within the next 10 years.

Let’s take a look at a very popular fund called American Funds AIVSX -Investment Company of America Class A shares:

The upfront commission (load) is 5.75{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df}.- The maximum that can be charged on A shares. The Fund Turnover is -23{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df}

The expense ratio disclosed in the prospectus is.61{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} However, the fund has the following costs in addition to the disclosed expense ratio.

Here is the breakdown of total cost of ownership: $100 investment

Your share of the fund’s transaction costs $29 /.29{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df}

Amount you paid for fund management $37 /.37{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df}

Amount you paid for fund distribution $23 /.23{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df}

Taxes you paid for holding the fund $31 /.31{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df}

One-Year Total Cost of Ownership $120 / 1.20{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df}

Source: personalfund.com

Now if you include the 5.75{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} commission, and a 1{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} advisor management fee, your actual cost of ownership is substantially higher than the.61{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} listed as the expense ratio. These fees are paid by the investor. You may not see them, but just as a termite works happily in the dark, walking away with one bite at a time of your home, these fees are quietly eating away at your investment return. If the performance is good, you may not mind paying higher fees. Some mutual funds and many Exchange Traded Funds have lower fees than this one and many may have better performance. This is where research and the work of a good financial planner with analytic skills come in handy.

This fund has a five-year performance according to Morningstar.com of -.22{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} as of Feb 2, 2012. By adding any additional costs of (1{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} advisor fee +.59{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} internal and transaction cost +.575{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} sales commission), your annual performance over the last five years would be reduced to-2.39{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df}. (1.39{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} if there were no additional advisor fee charged.) In other words On a $10,000 investment in this fund, you would have paid $178 a year for the privilege of losing $139 per year. If your holding period was shorter than 10 years your cost per year could be even higher.

Remember that advisor fees may be tax-deductible, but the mutual fund fees you are paying are generally not. Most online cost services do not consider advisor fees in their information.