Earlier today, I discussed some of the basic benefits of mutual funds: simplicity, diversification, and solid returns. Of course, these benefits come with a price: there is no free lunch on Wall Street (or anywhere else).
Here are some of the most common expenses that are associated with mutual funds. As a thrifty investor, you’re going to want to avoid these expenses as much as possible, so I’m also giving some tips on how to avoid the fees or at least minimize them.
Turnover This refers to buying and selling that occurs within a fund. Not only do these have their own costs (such as brokerage fees), but they also eventually cost the holder of the fund capital gains tax on all of those exchanges. In short, a fund with a high turnover can be really expensive to maintain, even if on paper it appears as though the fund has great gains.
How to avoid it Look for funds with low turnover. If you can’t find information about turnover on the fund, ask. Usually, most index funds have extremely low turnover.
Management fees Funds have to have someone managing them, right? And management has some costs associated with it, right? This is the portion that pays for the people actually doing the work to keep the fund running.
How to avoid it Index funds generally have little management effort required (as they’re composed of a publicly available list), so they usually have a very low management cost associated with them.
12b-1 and other service fees Often, funds charge additional fees for such things as advertising (that’s what 12b-1 fees usually cover), legal fees, registration fees, accounting fees, and so on.
How to avoid it Look for discount brokerages (like Schwab, E*TRADE, or Ameritrade) rather than full-service brokerages, or deal directly with the fund group themselves (like with Vanguard at vanguard.com).
In other words, a great strategy for a beginning investor to minimize fees when they’re just getting their toes wet in mutual fund investing is to buy an index fund directly from a management company. In fact, that’s exactly what I do, and I’ll discuss my investment choices a bit tomorrow.