Mutual Funds: Fees, Share Classes and Abusive Practices

Mutual funds are considered one of the safest ways to invest for the future.  In fact, most Americans own them in their employer retirement accounts.  Yes, mutual funds can be safe, especially in comparison to individual stocks.  Why buy just one stock when you can hold the entire industry or index?  That way, if one company falters, it doesn’t impact your account as much. Additionally, you get professional managers watching your money for you.  But along with these benefits, there are some dangers you should be aware of as well. 

When it comes to any investment, of course, there is always risk.  There’s no guarantee that the fund you choose will rise in price. That risk is inherent, so you can’t change that.  But there are other risks that you can control.  The key to managing these risks is getting educated so you know how to avoid these pitfalls. 

Mutual Fund Fees:  Are You Paying Too Much?

The first issue is the cost of the mutual funds.  Like any business, mutual fund managers must charge a fee for the services they provide.  But since that fee is separate from the price you pay for the investment, it’s not always easy to know exactly how much it costs. 

But it is critical that you find out, as this cost comes directly out of your pocket.  By selecting a lower-fee fund, you can keep more of what you earn, so it pays to shop around.

Most mutual fund fees are paid out of the fund itself, so you’ll never see a bill.    Instead, the onus is on you to figure out how much has been deducted from your holdings. Fortunately, the internet has made this easier.  Just look for the fund’s “Expense Ratio,” which represents your annual cost in percentage terms.

You can expect the annual expense ratio to vary based on the type of mutual you are buying.  For example:

• Passively managed index funds don’t require extensive management, so they usually have the lowest expenses.  According to Investopedia.com[1], these average about 0.2% per year.

• Funds requiring active management will charge more. You can expect to pay between 0.5% and 1% per year.  However, some funds charge even more, sometimes up to 2.5% per year.

There may be other fees, in addition, that you are on the hook for as well:

• The fund’s trading expenses for buying and selling securities are not included in the expense ratio. 

• If the fund charges “loads” or redemption fees for buying or selling the fund, those are not included either.

You can use this tool to help find all of the fees for mutual funds you own or are considering:  https://tools.finra.org/fund_analyzer/. 

Then, if you’re paying a financial advisor to select funds for you, that’s another layer of fees. Of course, extra fees may not always be negative; you just need to make sure you are getting additional value for them. Many people don’t think one or two percent is a big deal.  With money, a percentage or two per year compounds.  So that tiny percentage over time can eat into your returns; or, in down years, exacerbate your losses.  Since you’re likely to invest over decades, a small percentage could end up costing you hundreds of thousands of dollars[2].  So it is well worth your while to shop around for lower-fee funds.     

Do You Get What You Pay For?

As consumers, it is easy to think that cost indicates value.  For example, if you pay more for a well-known brand of refrigerator, you usually expect a much higher quality product.  But that’s not necessarily the case with mutual funds.  Research by Morningstar[3], a leading mutual fund research company, showed the complete opposite.  If you pay more, your mutual fund is more likely to underperform peers since the high cost is a drag on its performance. So don’t assume you are paying for quality; you may just be paying more to get less. 

So as you can see, it’s usually worth your while to do some research to make sure you choose mutual funds with lower fees.  But there is a twist to that too.  Some mutual funds offer different share classes. With those funds, each class is similar; it owns the same individual securities and has the same objectives, management, and policies.  The only difference is that each class has different shareholder services and, as a result, varying fees and expenses.  As an investor, you’re expected to select the class that best fits your needs. The problem?  It’s confusing, and few consumers have time or background to learn what these classes mean. 

For more information on share classes, here’s a good overview[4]. 

As you can see, selecting the wrong mutual fund may create problems for you.

Broker Abuses: Beware of Mutual Fund Switching

The reality is that most people are busy and don’t work in finance, so they prefer to use a financial advisor to help them invest. That can be a great help and a time saver.  However, it can also introduce another element of risk: that your advisor may be putting their interests before yours.  Most mutual funds, when sold by a financial advisor, pay them a commission.  Here’s the key: mutual funds are designed to be long-term investments. Because there are usually transaction costs for you, you benefit only when you hold them for a long time.  But your financial advisor only benefits when you buy or sell them.

This creates a conflict of interest.  The temptation may be too much to resist for some advisors, and they may recommend you switch mutual funds more often than you should. 

How Common is Mutual Fund Switching?

Unfortunately, switching is a common occurrence not necessarily detected by investors.  There are very few reasons you should switch mutual funds.  Usually, a broker will do it simply to generate more commission.  In that case, it is unethical, but that doesn’t mean it can’t happen.

And sadly, it does happen much more than it should.  Here are some of the firms (or their representatives) that have been penalized for mutual fund switching:

• Barclays Capital was fined $14 million for practices including mutual fund switching

• LPL Financial was fined nearly $12 million[5] for mutual fund switching and associated abuses

• Merrill Lynch was fined $5 million for mutual fund switching through its call centers

• An Ameriprise broker was suspended and fined for allegedly generating $450,000 in commissions from mutual fund switches over two years
• Cetera Advisor Network was fined $1.4 million for mutual fund trading and other unsuitable practices

And these are just the ones reported to FINRA.  There are likely many other instances where customers were not aware that these transactions were improper. 

Switching to Proprietary Mutual Funds

Even worse, many of the big Wall Street brands have their own proprietary mutual funds.  Usually, these carry higher fees than many of the other brands out there.   Because these funds represent a profit center for these firms, many of these companies push their advisors to recommend these funds to you, even though there may be cheaper alternatives.  So along with incurring unnecessary transaction fees, you may be getting switched to an even more expensive product that offers you no increased value. As an investor, you’re already forced to take on risks. As you can see, it is critical to avoid taking on the additional risk of harmful financial advice or abusive practices.

Fortunately, there is one strategy that can help you avoid these issues.  That is by hiring a financial advisor who is required to act as your fiduciary. A fiduciary is legally required to put your interests first.  These firms are structured to minimize conflicts of interest.  Usually, you’ll pay a fee for advice instead of compensating them on commissions.  So before you hire an advisor, ask if they are willing to act as your legal fiduciary. Then ask them to put it in writing. Quality financial advisors appreciate educated clients, so they will welcome this question.  With others, you may get an awkward response.  Consider that a valuable red flag that may save you significant money down the road.