Expense ratio is percentage of total assets that mutual fund charge an investor annually for managing their money. Investors should pay attention to expense ratio as your overall returns gets impacted in long term.
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What are the various fees charged?
The expenses related to Mutual Funds fall into 5 categories- Distribution charges, securities transaction fees, management fee, investors transaction fees and fund services charges. Some of these expenses reduce the value of an investor’s account & others are paid by the fund and reduce net asset value (NAV)
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Recurring fees and expenses, specifically the 12b-1 fee, the management fee & other fund expenses are included in a fund’s TER (Total Expense Ratio) or “expense ratio”. Because all funds must compute an expense ratio using the same method, investors may compare costs across funds.
This is paid to the management company or sponsor that organizes the fund, provides the portfolio management or investment advisory services & normally lends its brand to the fund. The fund manager may also provide other administrative services. The management fee often has breakpoints, which means that it declines as assets (in either the specific fund or in the fund family as a whole) increase. The management fee is paid by the fund & is included in the expense ratio.
The fund’s board reviews the management fee annually. Fund investors must vote on any proposed increase. But the fund manager or sponsor can agree to waive some or all of the management fee in order to lower the fund’s expense ratio.
This category of charges is used to pay for marketing, distribution of the fund’s shares as well as services to investors. There are 3 types of distribution charges:
Front end load or sales charge- It is a commission paid to a broker when a mutual fund is purchased. It is expressed as a percentage of the total amount invested or the “public offering price”, which equals the NAV (Net Asset Value) + the front end load. The front end load often declines as the amount invested increases, through breakpoints. The front end load is paid by the investor & it is deducted from the amount invested.
Back end load- Some funds have a back end load, which is paid by the investor when shares are redeemed. If the back end load declines the longer the investor holds shares, it is called a CDSC (Contingent Deferred Sales Charges). Like the front end load, the back end load is paid by the shareholder & it is deducted from the redemption proceeds.
12b-1 fees- Some funds charge an annual fee to compensate the distributor of fund shares for providing ongoing services to fund shareholders. This fee is called a 12b-1 fee, after the SEC rule authorizing it. The 12b-1 fee is paid by the fund and reduces NAV (Net Asset Value).
A no load fund does not charge a front end load or back end load under any circumstances & does not charge a 12b-1 fee greater than 0.25% of fund assets.
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Securities transaction fees
A mutual fund pays expenses related to buying or selling the securities in its portfolio. These expenses may include brokerage commissions. Securities transaction fees increase the cost basis of investments purchased & reduce the proceeds from their sale. They do not flow through a fund’s income statement & are not included in its expense ratio. The amount of securities transaction fees paid by a fund is normally positively correlated with its trading volume or “turnover”.
Investors transaction fees
Investors may be required to pay fees for certain transactions. For example, a fund may charge a flat fee for maintaining an individual retirement account for an investor. Some funds charge redemption fees when an investor sells fund shares shortly after buying them (usually defined as within 30, 60 or 90 days of purchase), redemption fees are computed as a percentage of the sale amount. Shareholder transaction fees are not part of the expense ratio.
Fund services charges
A mutual fund may pay for other services including-
- Board of directors or trustees fees & expenses
- Custody fee- Paid to a custodian bank for holding the fund’s portfolio in safe keeping & collecting income owed on the securities
- Fund administration fee- For overseeing all administrative affairs such as preparing financial statements & shareholder reports, SEC filings, monitoring compliance, computing total returns & other performance information, preparing/filing tax returns & all expenses of maintaining compliance with state blue sky laws
- Fund accounting fee- For performing investment or securities accounting services & computing the NAV (Net Asset Value)
- Professional services fees- Legal & auditing fees
- Registration fees- Paid to the SEC & state securities regulators
- Investors communications expenses- Printing & mailing required documents to investors such as investors reports & prospectuses
- Transfer agent service fees & expenses- For keeping investors records, providing statements & tax forms to investors & providing telephone, internet & or other investor support & servicing
- Other/miscellaneous fees
The fund manager or sponsor may agree to subsidize some of these other expenses in order to lower the fund’s expense ratio.
Critics of the fund industry argue that fund expenses are too high. They believe that the market for mutual funds is not competitive and that there are many hidden fees. So that it is difficult for investors to reduce the fees that they pay. They argue that the most effective way for investors to raise the returns they earn from mutual funds is to invest in funds with low expense ratios.
Fund managers counter that fees are determined by a highly competitive market & therefore, reflect the value that investors attribute to the service provided. They also note that fees are clearly disclosed.
Expense Ratio – Direct vs Regular Plans
Currently, there are two types of mutual funds plans — direct and regular — available to the investors .
Regular plans have an indirect commission paid to the distributors while direct plans have no commission. As a result, direct plans have higher returns than regular plans.
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