How much are you paying for the privilege of investing? There are many ways for investment companies to make money from investors:
- Sales charges
- Expense ratios
Commissions can be a flat fee or a percentage of a transaction paid in order to execute said transaction. For individual stocks, commissions to buy / sell a stock are generally the only expense for holding individual stocks. Some brokerage platforms allow commission free trades provided certain conditions are met. (e.g. minimum balance)
Some mutual funds charge you a "load" (percentage) to buy shares, and some when you sell them. These charges can be up to 10% or more. Typically there are two mutual fund share classes, Class-A funds charge an up front "load" / sales charge / fee when you buy, and Class-B funds charge a "back end load" / sales charge / fee also known as a Contingent Deferred Sales Charge (CDSC) when you sell. Class-A shares typically have lower ongoing expenses and no surrender charge to sell shares. Class-B shares have higher ongoing expenses and the "surrender charge" for Class-B will reduce to 0% if held for 5-10 years. Once this holding period is met, Class-B shares can be converted to Class-A shares to reduce ongoing expenses. A third share class, Class-C, may also be available which has lower front-end / back-end loads and carry a higher overal expense ratio.
Some mutual funds do not implement sales charges and these are called "no-load" mutual funds. There are no fees to buy or sell no-load mutual funds, however some trading platforms may charge a fee or commission to buy / sell competing companies mutual funds. Some no-load funds contain purchase or surrender fees which are paid back into the mutual fund to protect other investors from excessive trading. Information regarding sales charges can be found in the prospectus for each mutual fund.
Mutual funds and Exchange Traded Funds (ETFs) charge a fee for managing the fund called an expense ratio. Included in this fee may be 12B-1 fees to cover marketing & distribution, and other overhead for managing the fund. This fee is a percentage of your investment and is built-in to the fund and is deducted from the fund price (aka net asset value - NAV) at the end of each trading day. In other words, you don't pay for it separately. Expense ratios can be as low as 0% for some index funds. Expense ratios lower than 0.10% (or 10 basis points) are very good. Expense ratios for some investments can be as high as 1% or 2%. While 1% does not sound like much, this calculator visualizes the impact of a 1% fee over long periods. All of the area shaded in red and orange below are expenses and compound growth that are part of the total market return. Even with no sales charge, a market return of 6% with a 1% expense ratio results in almost 39% of your total market return lost to expenses over 50 years. There are no expense ratios for holding individual stocks. The only expenses for individual stocks are the commissions you pay to a broker to complete the transaction.
Compound interest is the 8th Wonder Of The World. He who understands it, earns it. He who doesn't, pays it.Albert Einstein
Using this tool, you can adjust the expense ratio, sales charge and time period and click on the details button to see the magic of compounding. This tool models purchasing Class-A shares with an up front load.