Mutual funds pool investors' money to buy stocks, bonds and other securities. The funds incur various costs, such as management compensation and trading commissions. Mutual fund investors bear these costs in the form of management fees, marketing fees, redemption fees and other charges. The United States Securities and Exchange Commission requires the disclosure of these fees in a mutual fund's prospectus, which describe the fund's investment objectives, historical performance and main risk factors.
Management fees are paid out of a mutual fund's assets to the fund manager for providing portfolio management services. Actively managed stock funds tend to have higher fees because they incur higher trading and research expenses. Passively managed funds, such as index funds and exchange-traded funds, have lower fees because they track benchmark market indexes. Active management means that the fund manager buys and sells securities based on fundamental research, technical and industry analysis. Passive management is less expensive because the fund manager sets up a portfolio of stocks to track a benchmark market index, such as the Dow Jones Industrial Average, and adjusts the portfolio only when there is a change in the underlying index.
A mutual fund's expense ratio is the ratio of the total annual operating expenses to the average net assets, expressed as a percentage. The operating expenses include management fees, distribution fees and other expenses. Distribution fees, also known as 12b-1 fees, are paid from the fund's assets to cover the expenses for marketing and certain shareholder services, such as responding to investor inquiries. Marketing costs include advertising expenses, broker fees, and the publication and distribution of prospectuses and marketing literature. Other expenses include legal, accounting and administrative expenses. The expense ratios for actively managed funds are generally higher than passively managed funds.
Other fees include advisory fees, which are fees paid to investment advisers and financial planners for advisory services, and shareholder fees, which include sales and redemption fees. Sales charges may apply at the time of purchase or at redemption. No-load funds do not charge sales fees, but they may charge redemption fees for selling shares before a certain number of years.
In addition to the various fees, mutual fund investors pay taxes on dividend, interest and capital gains distributions from mutual funds. Tax-exempt funds, such as municipal bond funds, are exempt from federal income taxes and some state taxes, but investors must pay capital gains taxes on disposition. Investors should compare mutual fund fees because these fees can add up and reduce the effective return on investment. Investors should look for mutual fund managers with a consistent performance record, especially in down markets.