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Educational Programming Video

The Value Line Mutual Fund Survey
Program 10: Expenses

During the next several sessions, we will continue to discuss some mutual fund basics that every fund investor should know. This session will cover fund expenses.

Last time we finished up our discussion of fund loads, the fee you may have to pay to buy or sell shares of a mutual fund. This isn't where paying for a mutual fund ends. Fund companies are nice, but they aren't that nice. You also have to pay ongoing fees, lumped into a funds annual operating expenses, for the services that the fund company provides. These ongoing expenses are broken out to the management fees, distribution fees (commonly called 12b-1 fees), and "other" fees.

Management fees are pretty strait forward. This is the amount that you are paying to have your money invested for you; it's the asset management fee.

Managers are paid in a number of different ways. The most common is a simple flat fee. The group that is investing gets paid X% of the total amount of money that they are investing. Another common way that management fees are arranged is performance based. If the fund does well, the management group gets paid more. If the fund does poorly, the group gets paid less. Of course there is generally a base level of pay in this scenario so that the management group will make something even if the fund is a horrible performer, but the general logic is that this is an incentive based pay plan.

Distribution fees, meanwhile, are more commonly known as 12b-1 fees. The money collected from this fee normally serves one of two functions; it either pays for advertising or pays financial planners to push the fund. The big question here is "Are distribution fees really helpful to current shareholders?" The answer is that it depends. It is helpful in that the more assets a fund has, the less it costs to run the fund. When enough money is involved, economies of scale begin to set in. Also, money inflows help to offset any withdrawals that might force the manager to sell stocks before he or she wanted to. In other words, it helps to keep a stable portfolio. The flip side of this is that some investors might not want to pay for the fund company to advertise its products, essentially footing the bill for the company to accumulate assets. It is a difficult topic, with no real answer.

The last operating expense is the catch all "other" category. This is generally for back office work. The fee pays for annual reports, prospectuses, your monthly statements, and the salaries of all the fund representatives at the other end of the 800 line. These are basic things that need to be taken care of to provide you with acceptable service. Of course, some of these costs are often fixed in nature and some cost less per account based on economies of scale, but generally this category contains day-to-day operating expenses

All of these fees are then summed up into one number called the expense ratio. This number is expressed as a percentage of the fund's net assets. You can find the number, and a breakdown of its components, in a fund's prospectus. In the front of the prospectus, you will also find a section that highlights the actual dollar amount an investor would have paid to own the fund based on the expense ratio. This number, however, is an example based on a certain size portfolio. If your portfolio is larger or smaller, you would pay more, or less, accordingly.

When examining a fund, the expense ratio should be taken into consideration. It should not be the first thing you look at, but if your short list is down to two funds, it might be used to break the tie. The point being that you want to pay as little as possible for good performance. But don't buy a fund just because its expense ratio is low.

Within the bond universe, management fees play an important role. Bond fund portfolios are often very similar, and, as such, a bond fund with low expenses may have an edge over a bond fund with higher expenses. Within the equity universe, however, this doesn't necessarily hold true. Some really good funds have low fees, while other good funds have high fees, and, conversely, some really bad funds have high fees, while other bad funds have low fees.

The moral of this segment is use a fund's expense ratio to help select relatively inexpensive to own funds, but only after you have selected a group of funds that meet your investment needs.

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