Understanding Mutual Funds: Investment & Fee Language Explained + Decoded

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Estimated reading time: 11 minutes

So, you’ve decided to invest in mutual funds! Mutual funds are an excellent area for investment, especially if you’re just starting. Still, it’s hard to understand all the new language and terminology that’s thrown around in the financial world.

Where do you start? Moreover, what is the cost of investing in mutual funds? Is there a cost to investing? (Of course, there is always a cost — even with sound investments!)

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It’s essential to wrap your head around the different types of mutual funds. There are the various classes, and, of course, the fees associated with your mutual fund investments. Once we go through these terms and definitions, I can just about guarantee that you’ll feel like mutual funds are more accessible and easier to understand. You’ll know exactly which mutual fund investments make sense for your particular situation and lifestyle!

What is a Mutual Fund in the First Place?

To understand how mutual funds work, you need a little background information. An investment company professionally manages mutual funds. The company pools money from investors who own an undivided interest in the underlying fund. A mutual fund offers portfolio diversification.

A typical mutual fund consists of stocks, bonds, short-term money market (instruments) investments, other securities or assets. Funds can consist of one type of asset or a combination of all several types (stocks, bonds, and securities, for example). You may hear mutual funds referred to as an investment portfolio.

To help you make even more sense of mutual funds, we have a printable resource guide that’s available in our resource library. I highly suggest you print it out and keep it right next to you as you read through the mutual fund investment possibilities. This guide will help you feel confident about your investment choices. Get access to the guide (and the entire library) above.

What Are the 3 Types of Mutual Funds?

Now that you understand the basic definition of a mutual fund, it’s important to explore the common types. Many people think there are only two types — open-end and closed-end, which we’ll define in a moment — but there is also a third type called ETFs. Let’s explore a little about each type of mutual fund.

Open-End Mutual Fund (Traditional Mutual Funds)

Open-end mutual funds (Traditional Mutual Funds) are continuous primary offerings, which means they are always issuing new shares. You can invest in an open-end mutual fund whenever you want. These funds are continuously accepting money and offering distributions.

Open-end mutual funds are redeemable at the shareholder’s request, and takes place at the end of business. That this equates to is 4PM EST, at the fund’s net asset value (NAV).  Every share issued is considered a new share, and every share redeemed is destroyed.

Closed-End Mutual Fund (CEFs)

It logically makes sense that if open-end mutual funds are continuously issued and redeemable, then close-end mutual funds (CEFs) are the opposite. These funds are offered as a one-time (initial) public offering of shares (otherwise known as an IPO). They issue only a fixed number of shares, which can include common stock, preferred stocks, or bonds.

A closed-end fund doesn’t offer shares or redeem shares continuously. You can’t decide to spontaneously buy a car and take money out of a closed-end fund. Unlike an open-end fund, shares for closed-end mutual funds are traded in the secondary market. For example, these closed-end funds do not issue or redeem shares daily.

Also, the shares for a closed-end fund trade on an exchange intraday, like stocks.  Intraday means making the most profit possible by taking advantage of the movement of the stock market, before the end of business. This is how a day trader operates.

Exchange-Traded Funds (ETFs)

The third category of mutual funds are ETFs. While these aren’t exactly defined as “traditional mutual funds,” they are similar. These are an assortment of securities that are representative of the NASDAQ-100 Index, S&P 500, Dow Jones, etc. They trade on an exchange throughout the day like a stock.

ETFs are designed to replicate a specific market Index’s performance, not outperform them.  These also tend to have lower costs than an actively managed mutual fund, which is why some people prefer ETFs as an investment option.

Also, since the ETF’s capital structure is not closed like a CEF, a significant advantage is that ETFs are structured to shield investors from capital gains better than CEFs or an open-end mutual fund.

What is a No-Load Mutual Fund?

You may hear the term “no-load mutual fund.” This term means the fund doesn’t charge any type of sales load, though it may charge all the fees not associated with a sales load, including the annual operating expenses. With no-load mutual funds, there’s no cost to the shareholder, making it a socially responsible investment option.

What is a Breakpoint?

You may have heard the term ‘breakpoint’ tossed around in the mutual fund world. It’s important to understand breakpoints. The larger the investment in Class A shares, the less you’ll be charged. For example, if you invest $100,000 into a fund, you will be charged more than you would if you invested $1,000,000 into that same fund. This is all because of the breakpoint.

You can look at life insurance as an example as well — breakpoints are $100,000, $250,000, $500,000 and so on.  Explained more simply, you will most likely pay more for a $850,000 policy, versus a $1,000,000 policy, again, because of the breakpoint. So, why not just increase the death benefit and pay less?

What are the Classes of Funds?

If you want to make sense of mutual fund fees, one of the most critical pieces to understand is the way mutual funds are broken into different classes. There are Class A, Class B, and Class C shares. Most people invest in A and B shares. C shares usually refer to investments on an institutional level.

Class A Shares

Class A Shares: These types of mutual fund shares have a front-end load, which tends to have lower 12b-1 fees (or none). 12b-1 fees are the annual distribution fees, which are typically built into the expense ratio. These funds have lower annual expenses. If you’re looking into class A shares as an investment option, it’s important to look at the breakpoints. The sales charge is reduced for larger investment purchases (as I previously explained under breakpoints).

Class B Shares

Class B Shares: These types of mutual funds have a back-end load, which means it will have a contingent deferred sales charge (CDSC). In most cases, these fees are reduced the more years you hold onto the shares. These funds will also include 12b-1 fees (which are higher than class A shares) as well as the annual expenses. These shares often get converted to class A shares after 6 to 8 years.

Class C Shares

Class C Shares: The last class of shares is Class C. As I mentioned before, these shares are usually investments on an institutional level. Class C shares have 12b-1 fees, annual expenses, and include either (or, sometimes both) Class A or Class B shares. These usually have a higher yearly expense than Class A shares, but are generally equal to Class B shares. There is no conversion to class A shares from class C shares over time.

Mutual Fund Fees and Expenses Decoded

Once you’ve decided to invest in mutual funds, you’re going to want to look at the fees and expenses to help guide your choice. Understanding these different fees will help you make sure you’re making the wisest investment possible to maximize your eventual payout. There’s no way to avoid fees (of course—that’s how investment companies earn their money), but you can compare to find the best option.

Sales Charge (Load): A sales charge is what the investor pays when purchasing shares (Class A shares/front-end load) in a mutual fund or redeeming (Class B shares/back-end load) mutual fund shares. The Financial Industry Regulatory Authority (“FINRA”) rule caps mutual fund sales loads at 8.5% of the purchase or sale. Or, at lower levels, depending on other fees and charges.

Purchase Fees

Purchase Fees: The purchase fee is what some funds charge shareholders (this is separate from the Class A shares/front-end sales load) when purchasing a mutual fund. This also defrays costs associated with your purchase.

Contingent Deferred Sales Charges

Contingent Deferred Sales Charges: As mentioned above, the CDSC is a fee the investor will pay when redeeming shares (Class B shares/back-end load) from a mutual fund. If shares are held long enough (usually five or more years), there is often no longer an imposed sales charge.

Redemption Fees

Redemption Fees: The redemption fee is charged to shareholders (this is separate from the Class B shares/back-end sales load) when redeeming the funds from a mutual fund. This fee is meant to defray costs associated with the redemption.

Exchange Fees

Exchange Fees: A fee that some funds will charge shareholders should they decide to exchange (or transfer) their investment from one group of mutual funds to another group of funds within the same mutual fund family.

Account Fees

Account Fees: Some funds will charge an account fee for the maintenance of their account. This fee can also be imposed when the value of the investor’s account is less than a specific dollar amount (or minimum), as specified by the fund.

Management Fees

Management Fees: A management fee is a payment to the fund’s investment adviser for the investment management of the portfolio.

12b-1 Fees

Distribution/Service Fees (12b-1 Fees): This fee is an ongoing asset-based sales charge and is deducted from the investors’ account quarterly. These fees are used to pay the cost of distribution of a fund’s shares for:

  • Concessions
  • Advertising
  • Printing of the prospectus

The maximum 12b-1 fee is 1% of the total fund. Typically, this fee ranges from .25% to 1%.

Other Expenses

Other Expenses: As you look at your statement/prospectus, you may also see a line for “other expenses.” This category usually entails custodial expenses, legal and accounting expenses, shareholder service expenses, transfer agent expenses, and other administrative expenses. These expenses aren’t included in the Management Fees or Distribution/Service Fees.

Total Annual Fund Operating Expenses

Total Annual Fund Operating Expenses (Expense Ratio): This fee represents a fund’s annual operating expenses. This will vary between mutual funds, so when comparing, be sure to look for this. This ratio is a valuable guide to help you understand and analyze the various mutual fund fees.

Now that you’ve got a better idea of the types of mutual funds that are available and the fees charged, you’re more than ready when making your next (or first) investment!

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