How Mutual Fund Companies Make Money

When comparing mutual funds, one important thing to check is the expenses they charge their investors. Mutual funds make their money by charging fees, and these can vary widely.

There is often a reason for those variations in fees. If it is a managed fund, one or more professionals are actively tracking the fund's performance and deciding which assets to buy and which to sell from day to day. The fund's fees will reflect that. If it is a passive or index-based fund, constant decisions and adjustments are not necessary and the fees should be lower.

Mutual fund fees in general have been on the decline since 1996, in large part because of competition from exchange-traded funds (ETFs), which have very low fees. The average expense ratio of equity mutual fund fees as of 2023 was 0.42%. That's a 60% decline from the average in 1996. (The total expense of a mutual fund is expressed as a percentage per year of the total amount invested.)

Understanding Mutual Fund Expenses

Luckily, it's easy for an investor to find out what fees are attached to a mutual fund investment.

The Securities and Exchange Commission (SEC) requires fund companies to disclose shareholder fees and operating expenses in every fund prospectus. Investors can find this information in the fee table situated near the front of the prospectus.

If you're researching funds on the websites of mutual fund companies, you'll find the expense ratio of each fund listed prominently on the page describing it.

Fees are easily the largest source of revenue for mutual fund companies, though some companies make investments on their behalf.

Types of Mutual Fund Fees

The various fees charged to investors in a mutual fund may include purchase fees, sales or commission charges (also called fund load); deferred sales charges; redemption fees; account fees, and exchange fees.

A mutual fund is a pool of money from many investors that is used to buy and sell stock shares and other assets in the expectation that they will pay a profit. Investors in the mutual fund may make a profit in three ways:

• The fund may earn interest and dividend payments from its holdings.
• The fund may earn capital gains from selling assets held in the fund at a profit.
• The fund may appreciate, meaning each fund share will grow in value over time.

Shareholder Fees

Fund companies can attach an assortment of fees to their services and products, but where and how those fees are included makes a difference.

Sales charge fees, commonly referred to as loads, are triggered by the purchase of mutual fund shares by an investor. The investor pays an additional percentage of the purchase price at the time the shares are bought. Much of this fee goes to the broker or advisor who sold the fund to the investor.

There are different kinds of fund loads. The most common is the front-end load, which is immediately deducted when the shares are purchased.

The Financial Industry Regulatory Authority (FINRA) sets an 8.5% cap on front-end loads.

There may also be back-end loads that are charged when the shares are sold. The most common of these is called the contingent deferred sales charge (CDSC). This load tends to start relatively high and decrease over time, dropping to zero after a period of seven to 10 years.

Some fund companies charge purchase fees or redemption fees. These are paid entirely to the fund, not the broker. Purchase fees are charged when the shares are bought, and redemption fees are charged when the shares are sold.

In essence, management fees are highly dependent on the success of the fund and the continued trading of new shares by the public. The most successful funds see a lot of new money and tend to be highly liquid; more trading equals more fee income for the company.

Annual Expenses

Mutual fund companies have expenses that need to be recouped. Management fees are charged to pay the investment advisor, the administrative staff, research analysts, distribution fees, and other costs of operation.

Management fees are paid out of the fund's assets rather than charged directly to the shareholders. The SEC requires that management fees be listed as a separate item and not lumped in with the "other" expenses category, so investors can always keep track of which funds are spending the most on management compensation.

Distribution fees are commonly referred to as 12b-1 fees. Capped at 1% of the fund's assets, 12b-1 fees recoup the costs associated with marketing the fund and providing shareholder services.

Some of these costs are unavoidable: The SEC requires the printing and distribution of prospectuses to new investors. As the mutual fund space has become more competitive, particularly since the late 1990s, 12b-1 fees have narrowed, and shareholders have become sensitive to them.

No-Load Funds

Many mutual funds do not have sales charges. They are called no-load funds.

This doesn't mean they are free of fees. They may still defray marketing and distribution expenses through 12b-1 fees, though the SEC does not allow these companies to refer to themselves as no-load if the 12b-1 expenses exceed 0.25%.

Others, such as the Vanguard family of funds, do not have sales charges or 12b-1 fees at all.

No-load funds still earn revenue from other kinds of fee income, but these companies also tend to reduce costs to compensate for the lack of sales charge income. This may correlate to less active investment management and a more passive investment strategy for the fund.

The Bottom Line

Mutual funds charge various fees in order to make money. These same fees, however, eat into your investment returns. To keep as much of your profits as possible, you'll want to choose funds with the lowest fees that fit into your investment profile and goals.