Making Sense of Mutual Fund Fees

As we've mentioned, mutual fund companies may charge a host of management, marketing and administrative fees in return for their services — costs that often take investors completely unaware and nibble away at your returns. All of these fees are assessed as a percentage of your total invested assets.

The money comes out of the fund's profits before you are paid, so excessive fees eat away at your initial investment as well as future profits. Here's what you need to know about fees before you invest:

Every fund charges a fee to pay the fund manager and cover the overhead charges of running a mutual fund. These management fees, known as the expense ratio, commonly range from 0.35% to 2% of assets per year. The fees — which include 12b-1 fees, management expenses, and trading commissions — are taken off the top of the fund's profits.

The 12b-1 Fee — named for the SEC provision that allows it — is the annual fee charged for advertising and marketing. This fee is taken out of the fund's gross profits to help it attract new investors. These fees range from 0.25% to 1.0%. To confuse matters, some funds have inactive 12b-1 fees. They have installed the fee just in case they want to impose it in the future, but they aren't using it right now. Carefully read the prospectus to ferret out 12b-1 fees. Funds that don't charge 12b-1 fees use money from their management fees to pay for advertising and marketing — that's why management expenses vary so widely. We don't usually recommend funds that have a 12b-1 fee.

If you're not careful, mutual funds can "fee" you to death. Hefty operating expenses are handicaps that a fund may not overcome for years. Before you invest in any fund, look carefully at its fees (these costs must appear in the fund's prospectus — usually on page 2 or 3 — in a standard format that is dictated by the government). You should also check the prospectus about other charges the fund may have. For example, the fund may charge a load for re-investing your dividends.

Dolan Ah-ha!

Anytime you withdraw money from a mutual fund, or transfer money from one fund to another fund, the sale of shares and/or subsequent purchase of new shares is a taxable event unless the funds are in an IRA or other tax-deferred retirement account. Remember to keep careful records of your transactions.

Front-end load: Many mutual funds have what they call "loads," a fancy word for sales charges or commissions. Most mutual funds that impose a sales charge do so up front, when you buy the fund. This front-end load can range from 2.5% to 8.5%(!), which is the maximum the National Association of Securities Dealers (NASD) allows but is not very common.

How exactly does a load work? Well, if you send $10,000 to a fund, the amount of your money that will actually be invested to build your wealth will range from $9,150 to $9,750. The rest of your money goes to the salesman and the mutual fund company.

That means you are already in the hole before you even get started! Your fund will have to work twice (or maybe three times!) as hard to grow. And since we already recommended that you keep your expenses to 1% or less, we suggest that you stay away from these unnecessary high loads.

Back-end load: Another way funds hit you with a load is by charging a redemption fee — also known as a back-end load. This is a commission that is charged against your account when you sell your fund.

There are three ways funds can charge a back-end load:

• As a set percentage of your original investment (not on the balance after it's grown)
• As a set percentage of your fund's total value (including your investment and any growth)
• As a declining percentage that disappears over time (usually after five years).

With such hits to your bottom-line profit, you may ask, "Does it ever make sense to buy a fund with a load?"

99.9% of the time, the answer is no! There are an awful lot of excellent no-load funds out there, and chances are you will be able to find one with a good long-term track record that matches your investment objectives, so why pay a load? For example, a fund that has had superior returns for the last 5 years (54.3%) is BlackRock Latin America A (MDLTX). But, the fund charges a load of 5.25%. Investors could find a very similar fund, paying almost-comparable returns (50.77%), in the Fidelity Advisor Latin America A LW (FLTAX.lw) fund, which has no load.

Say you invested $10,000 in each fund. After five years, here's what you'd have:

• BlackRock Latin America: $14,620
• Fidelity Advisor Latin America: $15,077

As you can clearly see, you come out ahead in the fund with a lower return because the fees are significantly less — meaning you keep more of YOUR money!

But be careful! "No load" doesn't mean "no fees"! That's why it's so important that you do the research we've just talked about. Be sure to look into not only sales fees (if any), but also the cost of continuing management of both kinds of funds and how often the portfolio manager trades in and out of holdings. All of this affects the fees you pay, which in turn affects how much money you make off your investment. You might be surprised when you do the math!

And if you already own a mutual fund that charges front-end or back-end loads, don't feel you have to sell it just because of the load if you are happy with its performance. But try to avoid putting new money into a high-load and/or high-fee fund.