Most investors are familiar with mutual funds, but few understand how they work. The lack of interest in fund companies is not surprising; most people are not financial experts, and they have plenty of other things to worry about.
The size and type of fees vary from fund to fund, so some investors might make better decisions if they understood how mutual fund companies make money from them.
Funds make money primarily by charging investors a fee based on assets under management (AUM) as well as sales charges that function like commissions.
An investor can find this information in the fee table at the front of a prospectus, which is required by the Securities and Exchange Commission (SEC).
Basic mutual fund companies generate the bulk of their revenue from fees, though some companies may make separate investments.
A potential fee can be incurred through the purchase of an investment, the sales of an investment, the redemption of an investment, the account fee, or the exchange fee.
mutual funds make money
How do mutual funds make money?
- Investors make money by paying a percentage of assets under management and may also be charged a sales commission (load) upon redemption or purchase of funds.
- Based on the fund’s operating costs and investment style, fund fees can range from close to 0% to more than 2%.
- Investors or potential investors must be informed about fund fees in the prospectus.
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Understanding Mutual Funds
The combination of flexibility, low costs, and the possibility of high returns makes mutual funds among the most popular and successful investment vehicles.
Mutual funds differ from savings accounts or certificates of deposit (CDs) at a bank. A mutual fund is actually a company’s stock that you purchase.
It is an investment company. Investing in securities is the business of mutual funds, just as making cars is the business of Ford.
Mutual funds have different assets, but their goal is to make money for shareholders.
There are three ways for investors to make money. The first way is through interest and dividend payments from the fund’s holdings. Investors can also profit from the trades made by management.
When a mutual fund earns capital gains, it is legally required to distribute the profits to shareholders. These distributions are called capital gains distributions.
The last method is to increase the value of the mutual fund shares through standard asset appreciation.
Shareholder Fees
It is important to determine where and how fees are included in fund companies’ services and products. Having mutual fund shares by an investor is an important consideration.
A percentage is added to the actual price of the share, usually something like 5%. A substantial portion of the sales charges goes to the brokers and advisors who sold the funds, so fund companies rarely retain the entire revenue.
Loads for funds come in different forms. A front-end load is one of the most common charges, which is deducted before an investment is actually made.
- There is an 8.5% cap on front-end loads set by the Financial Industry Regulatory Authority (FINRA).2 For example, when you invest $1,000, $50 goes to the broker and $950 to the mutual fund.
- When shares are sold, the buyer can be charged back-end loads. A contingent deferred sales charge (CDSC) is the most common type of charge.
- After a period of about seven to ten years, the load tends to decrease, usually dropping to zero.
- A few fund companies charge the buyer or seller a redemption fee. While these charges resemble sales commissions, they are paid entirely to the fund, not the broker.
Shares are purchased with purchase fees, and shares are redeemed with redemption fees.
Fund management fees are highly dependent on the performance of the fund and the number of new shares issued by the public.
The most successful funds see a lot of new money and have an elevated level of liquidity. More trading equals more fees for the firm.
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Annual Fund Operating Expenses
- There are expenses that mutual fund companies must cover; they can’t operate for free. The fund’s administrative staff, fund research analysts, distribution fees, and other operating costs are covered by these fees.
- Rather than being charged directly to the shareholders, management fees are deducted from assets. In order to allow investors to always track which funds spend the most on management compensation, the SEC requires management fees to be listed separately and not lumped in with “other” expenses.
- 12b-1 fees, which are commonly called distribution fees, are the most common distribution fees investors hear about. Shareholders pay 12b-1 fees, which are capped at 1% of assets, in order to recoup marketing costs and shareholder service costs4.
- Some of these costs are necessary, such as sending prospectuses to new investors. Particularly since the late 1990s, the mutual fund space has become more competitive, leading to a narrowing of 12b-1 fees. Shareholders have become more sensitive to these fees as well.
- Depending on the share class, 12b-1 fees differ. Most Class A shares are subject to front-end loads and have lower 12b-1 fees, and some mutual funds charge lower front-end loads based on investment size.
- The industry calls this “breaking points.” The mutual fund company is willing to give up some of its revenue on a per-share basis to entice investors to buy more shares. A Class A share has lower expenses than a Class B or Class C share.
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No-Load Funds
- There are a lot of no-load mutual funds, which do not charge sales charges. They do, however, still charge fees.
- Even so, the SEC does not allow these companies to call themselves “no-load” if their 12b-1 expenses exceed 0.25%.6 Others, such as Vanguard family funds, have neither sales charges nor 12b-1 fees at all.
- In addition to earning other types of fee income, no-load funds tend to reduce their costs to compensate for the lack of sales charges. Typically, this translates into passive investment strategies and less active investment management.
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