Which fees are the most important when investing in Mutual Funds?

Which fees do you have to pay?

When investing in Mutual Funds, you face several charges. Two of the most important matters of expense are sales commissions and management fees. In this article I will show on which fee you should pay more attention. Before comparing, let me briefly introduce:

  • Sales commissions (also: front-end loads) are paid upfront each time you make a new deposit. Typically, this fee is denoted as a proportion of the deposit, e.g. 3%.
  • Management fees (also: ongoing fee or operating expense) are charges that compensate the vendor of the fund for running it. This fee is also denoted as a percentage value (e.g. 1.5%), but is deducted from your total assets, i.e. absolute management fees increase in portfolio value.
  • In addition to that there might be further charges like redemption fees (when you sell shares) or service fees. To keeps things short, the following comparison will focus on sales commissions and management fees:

Which fee is the most important?

Assumptions

To compare matters of expense, let´s introduce a numeric example. Assume, at the beginning of each year, we make a gross deposit of $10,000. We will compare an investment in three funds (A, B, and C).

  • Fund A does not include any charges
  • Fund B only charges a sales commission of 3.0%
  • Fund C is limited to a management fee of 1.5%

Assuming an (riskless) annual gross return of 3%, how much will portfolios be worth in 20 years? As sales commissions (3.0%) seem larger than management fees (1.5%) one would likely expect those to be more important. However, I will show that exactly the opposite is true:

Fund A

 Fund_A = \sum\limits_{t=1}^{20} \text{\$10,000} \cdot (1+0.03)^{20} = \text{\$276,764.90}

Fund B

Our annual gross deposit is reduced by the sales commission as the sum of deposit and sales commission must amount to $10,000. Thus, the net deposit is given by $10,000/1.03 = $9,708.38 (in other words: we pay an annual sales commission of $291.62).

 Fund_B= \sum\limits_{t=1}^{20} \text{\$9,708.38} \cdot (1+0.05)^{20} = \text{\$268,693.80}

Fund C

Now, gross deposit equals net deposit, but annual returns are reduced by the management fee. To adjust the gross return for fees, we calculate (1+0.03)*(1-0.015) -1 = 0.01455 = 1.455%. This gives:

 Fund_C= \sum\limits_{t=1}^{20} \text{\$10,000} \cdot (1+0.01455)^{20} = \text{\$233,564.50}

Obviously, management fees have a greater impact on your final wealth (-16% compared to -3%). The reasoning is as simple as important: While the commission fees are merely paid on your annual deposits (and remain constant), absolute management fees increase in portfolio value.

Conclusion

In conclusion, you should direct your attention to management fees rather than sales commissions. An easy way to reduce operating expenses is to invest in ETFs (Exchange Traded Funds). If you want to learn more about ETFs, you should also see Why ETFs are a good start for you investment career.

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Author: Admin
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