Do you know exactly what you pay in mutual fund fees? If you’re like many retail investors, probably not. But over time, substantial money is at stake. Below is a quick primer on mutual fund fees. Even seasoned investors could use a refresher on this topic.

Always check the fund’s expense ratio, which is stated in the fund prospectus. The fund’s expense ratio is its annual operating expenses divided by its average annual net assets. An expense ratio is the percentage of your assets a fund claws back each year as payment for its services.

All mutual fund investors face annual charges and deductions for various ongoing expenses, the majority of which are tabulated in a fund’s expense ratio. That is, if a fund manages assets totaling $400 million and charges $2 million, it would report an expense ratio of 0.5%.

The average expense ratio for actively managed mutual funds is between 0.5% and 1.0%. For passive index funds, the typical ratio is about 0.2%. Most analysts consider an expense ratio of 1% or less to be reasonable.

Although we all know of high-cost funds whose performances seemingly justify their expense ratios, history demonstrates that expensive funds are more likely to lag the market.

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From 2017 through 2021, the average expense ratio for passive funds declined 8% and the average fee for active funds declined 12%. Greater competition and savvier investors are contributing to the decline.

It’s still your responsibility to educate yourself about fees and expense ratios. If you hold an unusually expensive fund, ask yourself if it’s worth it.

Let’s take a look at the major components of the expense ratio.

The ways in which funds pick your pocket…

There are several elements to the expense ratio. Management fees are paid out of the fund’s assets to compensate the financial professionals who construct and maintain the fund’s investment portfolio. This category also includes any administrative fees, which pay for mailing prospectuses, annual reports and account statements to shareholders.

So-called 12b-1 charges constitute another major component of the expense ratio and are paid out of the fund’s assets. Charges that fall under this heading generally relate to marketing and distribution expenses, as outlined by the U.S. Securities and Exchange Commission.

In some ways, marketing and distribution fees benefit investors: Advertising the fund should increase its assets, which in turn provides better economies of scale and lowers operating expenses.

At the same time, however, 12b-1 fees oftentimes further enrich brokers that sell the fund to clients, raising questions about the extent to which personal gains trump sound financial advice. Prospective investors can determine exactly how much a fund spent on broker compensation by consulting its statement of additional information.

A fund company’s 12b-1 plan may also include fees related to shareholder services, for example, to hire staff that respond to investor inquiries and provide shareholders with information about their investment.

The costs a fund incurs when it buys and sells securities are another ongoing expense. Brokerage costs aren’t included in the expense ratio but, instead, are listed separately in a fund’s annual report or statement of additional information.

Also be aware of commissions and other one-time costs when you buy, sell, or exchange shares of a mutual fund.

Over time, seemingly negligible differences in fees and expenses can substantially reduce an investor’s earnings. For example, if you sink $10,000 in a fund with a 10% annual return and yearly expenses of 1.5%, after 20 years the value of your investment would have grown to just under $50,000. Not too shabby. But if you had put this money into a fund with annual expenses of 0.5%, your return would be more than $60,000.

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