A Guide to Understanding Mutual Fund Fees

Investors should read the fine print to find out about fees that affect their bottom line.

House made of cash and coins

Look closely at expense ratios and turnover ratios before deciding to invest in a fund.

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Fees are the shiny objects in the fine print of a mutual fund prospectus. Inevitably, investors’ attention rivets on the expense ratio, which frames the ongoing cost of owning the fund, often to the exasperation of independent financial advisors. Here’s what you need to know about that ratio, as well as lesser-known fees that affect the amount of money you reap for investing in a fund.

Fees are important not only because they siphon money from your return, but because they are correlated with fund performance, says Christine Benz, director of personal finance with fund research and ranking firm Morningstar.

"When we look at what factors are most important for fund performance, one thing we come back to is that low-cost funds tend to outperform. It’s the single data point that is predictable," she says. In other words, funds with lower fees not only tend to cost less, they also tend to return more.

And make no mistake: You are paying a fee. It costs money to manage a fund. And "no load" doesn’t mean "free."

That is the biggest misconception about funds, says Henry "Bud" Hebeler, a former chief forecaster for Boeing Co. and now a retirement finance analyst. "Fee information is buried," he says. If you are in an employer-sponsored plan, don’t rely on the bullet-pointed summary for all the key information. Take the time to excavate all fee-related details, Hebeler recommends.

[Read: A Guide to Financial Advisor Fee Structures.]

Those who do mine for fee information typically zero in on the expense ratio. That is the annual percentage of your money the fund management firm charges to manage the fund (including keeping that weighty prospectus up to date).

A 1 percent expense ratio means the fund keeps $1 for every $100 you have invested with it, every year. Most actively managed funds charge around 1 percent. A fund that is on algorithmic automatic pilot, such as an index fund, demands less human attention, so it might carry an expense ratio of 0.75 percent or much less.

Either way, that doesn’t sound like much, and that’s the problem, Benz says. The fee evaporates that sliver of money before you ever see it. "You don’t write a check, and you don’t see it on your statement," she says.

When fees become a swing factor. As your portfolio grows, you will start to diversify into other types of funds. That's when fee calculations become more tricky. When you are investing in a fund of household-name equities or bonds, such as companies in the Standard & Poor's 500 index, expenses can be a swing factor for your return.

Bond funds are typically comprised of similar types of investments, all promising similar returns. Fees can make a big difference when there is a narrow range of return, Benz points out. If a bond fund aims for a 3 percent return but takes 0.75 percent in fees, " … that’s a quarter of your returns," Benz says.

[Read: Are You Paying Too Much for Mutual Funds?]

But keep in mind that specialized equities or bond funds require more hands-on steering. They might have greater potential for return, but only if they are carefully managed. Careful management translates to higher fees, which may be worth it. You might start working with a commission-compensated financial advisor, and if he or she offers solid guidance, the commission might be worth it to get in on the specialized funds, Benz explains.

More fun with fees. The expense ratio isn’t the only number you should scour the fine print for.

"If you build your portfolio just based on expense ratio, you lose out on diversification. If you just focus on expense ratio, you load up on cheap stuff that’s all the same," says Gretchen Stangier, a certified financial planner and owner of Stangier Wealth Management in Portland, Oregon.

She zeros in on "turnover ratio," which tells you how often the fund manager is buying and selling stocks. For example, a turnover ratio of 85 percent means the manager sold 85 stocks and bought 85 stocks in the process of managing the fund.

A high turnover ratio hurts returns because managers have to pay for each of those transactions. "He’s digging a hole with transaction costs and has to make that up with return. That flows through to the investor," Stangier says. "The turnover ratio is an insight into the expense of running the fund."

This also explains why index funds, which are largely put on automatic pilot, tend to do better in the long term than actively managed funds. There is less fiddling with the contents of the fund, so there is less cost per fiddle.

[See: Find the Best Mutual Fund for You.]

The more complicated the fund, the more costs associated with extracting returns. That's why load funds can be worth it if you have the right advisor helping you find a fund that adds balance to your portfolio. To be clear, with a "back-end load," you pay a fee when you take your money out of a fund, and with a "front-end load," you pay upfront when you put money into a fund. Either way, the fees should be clearly explained, and your advisor should explain how the fund will earn enough to justify the load fees.

The most important takeaway, Stangier says, is that fund fees are an important factor, but not the only factor. She advises clients to not miss the returns for the fees. "People get so hung up on the expense ratio that they don’t get a diversified portfolio," she says.