Understanding fund fees and expenses
As an investor, you know that mutual funds offer many key benefits. They give you access to professional money management, provide portfolio diversification, offer convenient record- keeping, and make investing more convenient in general. These benefits are not without their costs, however. That's why it's important to understand the fees and expenses of a fund before investing in it. They generally fall into two categories:
- Sales charges or loads are transaction-based costs usually paid to a broker who has bought shares of the fund for an investor's account.
- Annual fees are costs paid by the fund (and thus, indirectly, by the investor) for
management of the fund and essential services, such as toll-free 24-hour phone and Internet access, account statements, access to knowledgeable staff, and shareholder reports and prospectuses. These fees are part of the fund's expense ratio. The expenses of a fund affect its overall performance.
Small accounts can be expensive for mutual funds
Consider a $500 account in a fund that charges 0.8% a year for expenses. The fund will collect $4 from the investor in fees. But generating and mailing quarterly statements and annual reports will easily cost the fund more than that. Funds often don't earn a profit on an account until it hits $10,000 or so.
Economies of scale can benefit you
In general, greater economies of scale are usually linked to an increase in the fund's overall assets. Small accounts within a fund may lead to increased expenses for all shareholders in the fund. The expectation is that a growing fund should be able to spread certain fixed costs across a larger asset base, resulting in a declining expense ratio. However, the problem with a fund with many small accounts is that each account has certain fixed expenses. The more small accounts in a fund, the more fixed expenses to be borne by the shareholders in the fund.
Administrative costs are often much higher for funds with many small accounts than for funds with fewer but bigger accounts. Small accounts can often be a drain on a fund, ultimately
reducing overall performance for all shareholders. Many firms counteract this with one or more of the following methods:
- Charging a fee to maintain low-balance accounts
- Raising minimum balance requirements for funds
- Liquidating those accounts that don't meet the minimum balance
What you can do
It's easy to do your part to combat the strain of fees in a portfolio and to enhance the
efficiency of a fund. Work with your advisor to ensure that your account balance in each
of the funds you own is at least at the minimum required. It's even easier with the increased IRA contribution limits of $3,000 for 2004 and $4,000 for 2005.
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