Mutual funds can be purchased by paying a commission to your broker or by paying an ongoing fee to your advisor. The amount of commission you pay is based upon the total value of the purchase within the same fund family. There are different breakpoints for paying a reduced commission and no load mutual funds which you may purchase without a commission, however additional deferred sales charges may apply. A fee-based financial advisor does not charge a commission, but you will pay an annual fee that can typically range between .5% and 2%. There are firms that specialize in managing portfolios of mutual funds as sub advisors and these sub advisors typically charge between .5% and 1%. If your advisor hires a sub advisor to actually manage your mutual fund portfolio, the overall combined fee could be 1% to 3% per year.
Once you have a portfolio of mutual funds, you need to understand the cost of continuing to own them. Most people are aware of mutual fund operating expenses, which include management fees, marketing costs and distribution costs. According to MorningStar, the average mutual fund charges 1.25% for operating expenses. What is not included in that number is the transaction costs that occur within a mutual fund. According to a study by Roger Edelen, a finance professor at the University of California, Davis, the average fund has trading costs of 1.44% per year. Mutual fund companies have objected to separately reporting transaction costs due to the complexity and financial burden of calculating these costs. Since the costs are not reported, it makes comparison of transaction costs impossible when comparing funds.
Income taxes can also add to the unexpected costs of owning mutual funds. Over the last 18 months the stock market has had significant gains and for the owners of mutual funds held outside of retirement accounts the sale of appreciated stocks by the fund manager can create taxable income. If the manager sells previously appreciated stock, you can be taxed on the gain even though you did not own the mutual fund during the period that the stock appreciated. For Hamilton County, Indiana residents the maximum tax rate on capital gains is 28.2% and the maximum tax rate on short-term capital gains is 47.8%. You or your advisor can usually find out the amount of embedded gains by contacting the mutual fund company. It can be a very unpleasant surprise to have to pay income tax when the value of your mutual funds may not have changed since the date of your purchase.
Mutual funds do have a definite place for investors. They can allow investors with smaller amounts of capital to gain proper diversification and exposure to professional management. They have also been greatly utilized by investors who do not want or have the skillset to pick individual securities in their portfolio. Every investor deserves to have full transparency that allows them to make the best informed decisions for their future and goals. The fee structure associated with cost of owning investments and receiving professional advice should be no different.
Investments involve risk including possible risk of principal invested. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a no-diversified portfolio. Diversification does not ensure against market risk. Neither Commonwealth nor Midwest Wealth Management offer tax or legal advice.
Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser.
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