Mutual funds, which are large investment pools that sell shares to the public, offer investors professional management and a diversified risk. In exchange for these advantages, you will be paying fees and expenses to the fund company as well as, quite possibly, a sales commission when you buy the shares. Loads and expense ratios provide you with a useful measure of how much the fund will cost, and your chances of actually earning a profit by investing.
Mutual funds come in two basic flavors: load and no-load. A no-load fund charges no up-front sales commission, while a load fund does. The commission comes out of your investment when you buy shares, and is paid to the adviser or broker who signs you up for the fund. Back-end sales loads charge this commission when you sell. In many cases, the percentage of a back-end load declines as your holding period lengthens, giving the investor incentive to keep the account open as long as possible.
Loads and Performance
Front-end sales loads represent an immediate loss of capital, provide no guarantee that the fund itself will outperform the market, and are none too popular with knowledgeable mutual-fund investors. An investor wishing to allow a skilled financial advisor to guide him to a superior mutual fund may pay a front-end load willingly, but research conducted by Morningstar and other financial companies has shown that load funds don't return better results than no-loads. Even no-loads, however, charge a variety of fees that come under the general heading of "expenses."
Expenses are charged by all funds, and represent the costs of operating the fund that are charged to investors (indirectly, out of fund assets). Common expenses include management fees, the salaries of back-office personnel that handle the customer accounts, and the expenses for marketing and advertising (also known as 12b-1 fees). To gauge these expenses, mutual fund investors can take a simple measure known as the expense ratio, which mutual funds are required to disclose in their prospectuses. This ratio represents expenses as a percentage of the fund's assets. If the fund handles $100 million in assets, and collects $1 million in fees and other charges from the fundholders, then the expense ratio is 1 percent.
Apples to Apples
Although expenses come under various guises, the expense ratio and the load percentages, taken together, will give you a pretty clear idea of how much a fund is charging and how it compares with other funds, cost-wise. A no-load fund with an expense ratio of 5 percent basically matches the cost of a fund with a 3 percent load and a 2 percent expense ratio. In general, index funds that simply follow the performance of a market index such as the S&P 500 will charge much less in commissions, expenses and fees than an actively managed fund, for which expensive managers are making the investment decisions. That is one crucial reason for the popularity, and relatively strong, market-matching performance, of index mutual funds.
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