Articles

Strategic Financial Planning: Avoiding Mutual Funds' Hidden Costs

By Jeremy Sorci | July 01, 2017

Are mutual funds free to invest in? This question is more common than you might think. The answer, unfortunately, is no. 

Jeremy Sorci is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt CountyIt is understandable to assume that something only costs money if you actually see cash flowing out. For example, commissions or transaction costs can be clearly identified (or at least should be) on an account statement.

Therefore, investors often assume that when they purchase a mutual fund with no commissions or transaction costs reflected on their account statement, the purchase is

free--aside from the actual underlying price of the mutual fund, of course.

Unfortunately, the old adage about “assuming” applies in this situation because a closer examination shows that mutual funds are not, in actuality, free to invest in.

Wealth Management Fees: They Add Up

Most mutual funds are essentially portfolios of stocks, bonds, or a combination of the two. The inclusion of specific assets into the fund is determined by the mutual fund manager.

The fund manager has to get paid for his or her services and therefore charges a fee. Unless you really do your own research or have an honest financial advisor, you will likely never know what that fee is because it doesn’t show up in your statement. It does, however, affect the value of the fund as well as your total return.

These fees can’t be avoided, so do your homework and find out what fees are being charged. Fund companies like Vanguard and Dimensional Fund Advisors are famous for their low fund management fees.

Wealth Management Services and 12b-1 Fees

Frequently, the investment professional or broker that sold you the fund is rewarded for his or her marketing efforts by collecting what are referred to as “12b-1” fees. After all, they got you to buy the fund, right?

Unfortunately, these fees are yet another cost that is not transparent on your statement. If the fee is high enough, it should raise questions regarding the seller’s motivation for recommending the particular fund to you as the investor. Was the fund recommended to you because it is the right fund for your portfolio or because it offers the financial advisor or broker a significant fee?

Just to muddy the waters even more, the advisor or broker collects the 12b-1 fee every year you own the fund. This could influence an advisor to keep you in a fund even when it’s not in your best interest. Ask your advisor if they collect 12b-1 fees off your investments and then compare them to those of similar funds available to you.

Don't Forget Loads in the Financial Planning Process

Jeremy Sorci is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt County

The hidden costs just keep mounting. Loads are expenses you pay to the fund manager either up front (front load), or upon sale of the fund (back load). In other words, the fund managers get paid immediately (without proving their skills) or when you sell your fund.

This may have you asking the obvious question, “Don’t I already pay them a management fee for their work?” Why yes you do. Front load or back load expenses are costs that are in addition to what you pay the fund manager.

The best way to avoid these is by purchasing institutional shares of funds, no-load funds, or buying a large enough amount of shares that you can waive the loads. Steer clear of A, B or C class shares.

Embrace Diversity in Your Comprehensive Financial Plan

This is more of an opportunity cost than a financial cost. Many funds require you to purchase a minimum dollar amount of shares in order to get into the fund. If money is no object, then a minimum purchase requirement isn’t a problem.

However, if you are an average investor, being forced to put a large portion of your nest egg into one fund means potentially being overweight in one area (due to the minimum) and underweight in others (due to less investable cash). This potentially leads to lack of diversity within your portfolio as well as missed opportunities – hence the opportunity cost of investing in mutual funds.

These are just some of the costs you may incur by investing in mutual funds. Depending on your advisor or broker, you may be paying transaction fees or flat fees on top of the costs mentioned. Review your management contract regularly and always keep in mind that nobody does anything for free when it comes to investment advice.

Posted in Diversification, Costs, and Fees

   
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