Q Dear Rick:
I am in my early 50s and have never invested before. I was at the Observer and Eccentric Expo a few months ago and I talked to you after your presentation. At that time I told you I inherited some money and you gave me some suggestions about how to invest that money without having to pay commission. You told me I could either buy the funds through Charles Schwab or Fidelity. I contacted both companies and they confirmed to me that I can buy these mutual funds without having to pay any commission. I received the inheritance and before I invested the money, I was contacted by a friend of a friend who is a financial advisor and he told me that even with no-commission mutual funds, you still pay fees. I am confused. You always say that it’s important to understand fees before you invest money; so my question to you is are there fees when you buy non-commission mutual funds and, if there is, what is the benefit?
Vince
A Dear Vince:
I love the fact that before you invest money you are focusing on fees. Fees are important. In fact, when you look at independent surveys they almost always tell you that low-cost investing equals higher returns. When investors don’t focus on fees they get taken advantage of by investing in products with high fees which means low returns.
In understanding fees when it comes to mutual funds you can basically break them down into two separate categories: 1) management fees 2) sales charges.
Every mutual fund, whether a commission or non-commission product, charges you an annual management fee. This fee compensates the mutual fund company for not only servicing your account but also, managing the money within the mutual fund. Even though every mutual fund has management fees, generally, the no-commission mutual fund will have much lower management fees. The management fee is not something you write a check for and you won’t see it come directly out of your account. Rather, the mutual fund takes that management fee off the top before interest, dividends and capital gains are distributed to the shareholders.
The other major fee and this is the one that distinguishes between commission and non-commission mutual funds, is the sales charge. The sales charge is known as the load in the financial world. The load is the commission that you pay the salesperson. Typically, loads are upfront which means that if you invested $10,000 in a seven percent loaded mutual fund, $700 would come off the top to pay your salesperson. Unlike a non-commission mutual fund where if you invested $10,000, the entire $10,000 would go to work for you. In a commission mutual fund, if you paid $700 in commission, only $9,300 would actually be invested. In an attempt to confuse investors, there are also a variety of other ways you can pay commission. Some mutual funds take money out of your account every year to pay a commission, while others will have what are known as back-end loads which means when you sell the investment before a certain period of time, you’ll end up paying commission then.
The bottom line is when the individual told you that every mutual fund has fees, they were correct. However, what all investors should be aware of is that commission mutual funds will typically have substantially higher management fees and in addition to the higher management fees will also have sales charges. As far as I’m concerned, these fees are unjustified. That is why I tell investors to avoid them. After all, the goal of investing is to make money and one of the best ways to do that is to have low-cost investments.
Good luck!
Rick is a fee-only financial advisor. His website is www.bloomassetmanagement.com. If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com