The Hidden Costs of Mutual Funds: Are They Worth It?

What Happened?

Mutual funds are often heralded as a tried-and-true method to grow wealth.

Unfortunately, many investors aren’t aware of the hidden costs involved.

In the same way that compound interest grows money, over time fees can erode your portfolio's returns. Understanding what you're paying in fees is critical when making any educated decisions…

Why it Matters

Management fees are a key component of the expense ratio of mutual funds. For actively managed funds, where financial professionals research and select specific securities, the fees are often higher.

That’s compared to passive funds, which simply track market indices. Management fees typically range from 0.1% to 2% of a fund's total assets.

Although actively managed funds tend to come with higher costs, they rarely outperform their passive counterparts. A study by the Securities and Exchange Commission (SEC) found no consistent link when it came to higher expenses and better fund performance.

As a matter of fact, over 80% of actively managed funds underperform their set criteria. This makes the case for lower-fee options like passive index funds even stronger.

The 12b-1 fee is the Big Kahuna when it comes to hidden mutual fund fees. Another component of a fund's expense ratio, it was initially introduced to help mutual funds grow by covering their marketing and distribution costs.

However, these fees have continued to be controversial since their inception. While 12b-1 fees are capped at 1% annually, the fees themselves are split between marketing expenses (up to 0.75%) and service fees (up to 0.25%). A (valid) criticism of these fees is that they offer little to no benefit to investors, and they serve primarily as a commission check for brokers.

Upfront sales loads and redemption fees are another set of hidden costs rarely taken into consideration by investors. ‘Front-load’ funds charge an upfront commission when shares are purchased, typically as a percentage of the investment amount.

Although many funds are ‘no-load’ and circumvent any upfront charges, they still may leverage purchase or redemption fees in order to cover any fund expenses.

‘Back-end load’ fees, or surrender charges, also penalize investors for selling any shares within a specific timeframe. These fees will typically range from 1% to 3%, and they often will decrease over time.

How it Affects You

There are a lot of moving parts when it comes to mutual funds, and fees are just one part of the equation. As of 2024, nearly 54% of American households own mutual funds. Due to their popularity, current and prospective investors need to weigh the benefits and shortcomings of adding mutual funds to their portfolios.

While mutual funds can be a solid option for investors, other low-cost alternatives such as index funds and ETFs (exchange-traded funds) continue to gain popularity with investors for both their transparency and efficiency.

Before committing to investing in a mutual fund, take care to consider not just its fee structure, but its flexibility, ruleset, and past performance. Also remember, when it comes to mutual funds, lower fees are typically indicative of better long-term results.

By staying informed on a particular fund's fees and choosing wisely, you will put yourself in an excellent position to make mutual funds work for you and be a benefit to your portfolio.