There are a number of explicit, implicit, and hidden costs associated with investing in mutual funds.

Explicit Costs

Explicit costs are fees and expenses that appear on your mutual fund statement each month.

Loads: A load is a sales charge that an investor must pay to purchase certain types of mutual fund shares. Front-end loads are charged when a fund is purchased and are essentially sales charges to pay the broker for selling the fund. Back-end loads are charged when an investor sells certain types of shares. Some funds use back-end loads to discourage investors from switching funds too often. Back-end loads are often given a sliding scale, which means that the longer you hold the shares, the smaller the back-end load. No-load funds do not charge a commission when funds are purchased or sold.

Management fees: Management fees are assessed to compensate the portfolio manager; these fees are generally based on a percentage of annual average assets (e.g., seventy-five basis points, or 0.75 percent per year of assets under management). These fees are assessed annually, but are taken out of the net asset value on a daily basis (i.e., the fund managers are paid daily).

Annual custody fees: Brokerage houses charge you a custody fee to hold mutual funds or ETFs in your account. The custody fee may be a fixed amount for small accounts. For large accounts, the custody fee may be either a specific charge per holding or a percentage of assets held.

Other fees: There are a number of other fees that may be assessed to your mutual fund, including 12b-1 fees, distribution fees, and transfer agent fees. A mutual fund charges investors 12b-1 fees to cover some of the costs of advertising and marketing the fund to new investors. The fund also charges distribution fees to cover the costs of selling the fund. The transfer agent fee is charged to compensate the transfer agent, or the company or institution responsible to make sure shares are transferred correctly, for maintaining the investor’s records.

Overall expense ratio: The overall expense ratio is the overall cost of all management fees, custodial fees, trustee fees, and other fees. The overall expense ratio represents the most important explicit cost that you should look at when evaluating mutual funds. An overall expense ratio of 2.25 percent means that the mutual fund must earn 2.25 percent before you will break even on your investment.

Implicit Costs

Implicit costs are expenses that must be accounted for to calculate the true return of your portfolio; these costs do not appear on your monthly mutual fund report. The implicit cost of investing in a mutual fund is taxes. You must pay taxes on the four main types of distributions: bond dividends and interest, stock dividends, short-term capital gains, and long-term capital gains.

Bond dividends and interest are distributions from bond mutual funds. These earnings are taxed at your marginal tax rate, which can be as high as 35 percent.

Stock dividends are earnings the mutual fund receives from stock holding. These earnings are taxed at 15 percent.

Short-term capital gains are earnings the mutual fund makes on assets it has held for less than twelve months. These earnings are taxed at your marginal tax rate.

Long-term capital gains are earnings the mutual fund has made on assets it has held for longer than a year. These earnings are taxed at 15 percent. Note that you must pay taxes only on realized capital gains, or the gains you receive when you sell an asset; you are not required to pay taxes on unrealized capital gains, or the gains you would make if you sold an asset.

 

• Hidden Costs

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