There are a number of things to understand before dumping your life savings into mutual funds, especially in taxable accounts.
In the mutual fund world, there are two primary types of mutual funds: open end and closed end. Chances are the vast majority of the funds in which you have been involved have been open ended funds.
Open ended mutual funds can be purchased directly from fund companies (Vanguard, Fidelity, et al) and also through your brokerage account. But before you purchase anything, particularly any type of fund, you should look at the costs involved. The fees and costs inherent in mutual funds are not always as blatantly clear as you might prefer.
Load Fees
A front end load refers to a percentage of your investment that is paid when you purchase the fund. If you use a stock broker, typically this is paid to him or her. A back end load refers to a percentage of your investment that is paid when you sell the fund. Again, with a stock broker, this is part of his or her compensation. A no-load fund does not have these particular fees.
Expense Ratio
This is a fee, expressed in terms of annual expenses as a percentage of the value of the mutual fund. It is actually comprised of three separate fees. The first of these three is the management fee, which is paid to the portfolio managers picking the stocks, making the trades, etc. The secondis the “Sub-TA” fee. This fee helps offset some of the legal and administrative fees of the fund. This is typically the smallest by far and is not always present. The last fee is the “12b-1” fee. This fee also compensates the broker. Depending on the fund and the share class you are in, this can be the largest of the three. While many of you are fortunate enough to have a great broker, it’s always a good idea to know what costs are inherent in your investments, and where they are going. Total expenses for a typical fund can range anywhere from 0.10% to 3.0% per year, obviously a huge range. This is why it’s especially important to know where your money is going. Saving 1.5% per year in costs over many years can compound into quite a difference in savings.
Another cost, outside the scope of direct fund fees, is the tax that can be triggered by a mutual fund. I’m referring to capital gains distributions and they are best illustrated with an example:
- March 1: XYZ mutual fund is worth $9/share.
- March 31: XYZ fund is worth $10/share. You buy 1 share for $10.
- April 10: XYZ makes a capital gains distribution for $1. This is paid to you in cash. When this happens, XYZ fund falls to $9.
- April 11: Now you own $1 of cash, and $9 of XYZ fund. You still have all $10 of your investment. However, that $1 payment to you is taxable as capital gains (can be short or long term or a combination thereof). At a 15% tax rate, you just lost $0.15 for that fund, in taxes, without the fund actually doing anything up or down.
The point here is that it is important to be aware of planned distributions, particularly when you are purchasing a mutual fund for a taxable account.
If you are looking for a passive indexing strategy, many times exchange traded funds (ETFs) are far better bang for your buck, and they don’t have negative tax consequences to boot.
Feel free to give DeMoss Capital a call if you’d like some direction with regard to where to look for these fees as you evaluate your funds.