The Bogleheads' Guide to Retirement Planning (23 page)

Sales loads:
You can divide mutual funds into two overall segments: pure no-load funds and load funds. Pure no-load funds can be purchased directly from the fund company without paying a commission. Load funds are purchased from a broker or other financial services salesperson by paying a so-called load. The load is simply a commission paid to the salesperson. It may be a front-end load, which is taken out of your initial investment amount when you buy, or a back-end load, which is deducted from your proceeds when you sell. There are some funds with front-end loads as high as 8.5 percent. That means that if you make a $10,000 investment in that fund, only $9,150 actually makes it into your account and $850 goes as a commission to the salesperson. That means you need to earn more than 9 percent on your $9,150 investment just to get back to even. Avoid the salesperson, invest directly with the fund company in pure no-load funds, and keep all of your investment money working for you.

12b-1 fees:
A mutual fund with a 12b-1 fee charges an extra expense to fund holders to use for advertising and promotion of the fund. This fee is paid by current shareholders in order to gather new shareholders. Although new shareholders would mean more money flowing into the fund, resulting in more profit for the fund managers, it’s generally not beneficial to the current shareholders. In fact, when a fund gets too big, it may start to resemble an index fund and move along with the market, negating any special advantage the fund may claim to have had when it was smaller. A 12b-1 fee is essentially another expense that further lowers the fund return that the individual shareholder gets to keep. Especially egregious are the mutual funds that are closed to new investors yet continue to charge shareholders the 12b-1 fee for advertising. Many load funds also come in a no-load version, but the no-load version charges a 12b-1 fee. That is the difference between a no-load fund and a pure no-load. The pure no-load fund has no 12b-1 fee.

Abnormally high expense ratios:
High expense ratios are inversely related to fund performance. The higher a fund’s expenses, the lower the investment gains the shareholders get to keep. A low expense ratio is the single most important reason a fund outperforms similar funds. For the long-term investor, these higher expenses can be very significant. Consider two funds that both return 10 percent a year before expenses. The low-cost fund with expenses of 0.2 percent would then have a net return of 9.8 percent. But the high-cost fund with expenses of 2.2 percent would have a net return of only 7.8 percent. Over a 30-year investment horizon, that would mean $10,000 invested in the low-cost fund would grow to $165,000 while in the high-cost fund it would grow to only $95,000. That’s a difference of $70,000, or seven times the original investment. Costs definitely matter.

Direct brokerage commission trading costs:
Buying mutual funds directly from the fund provider is the cheapest route. But many people hold funds and exchange-traded funds (ETFs) through a brokerage account of some kind. This has the advantage of allowing you to hold funds from multiple fund families, while still keeping everything consolidated in one account. The drawback is being charged a commission every time you buy or sell something. Purchasing ultra-low-expense ETFs through a brokerage account may seem like a sure way to savings, but if you are paying a commission for every transaction, it can quickly get expensive. That $9.99 commission may seem reasonable, but on a $1,000 transaction it adds another full percentage point to your costs. And don’t forget you have to pay the $9.99 to sell, too. So while the 0.1 percent expense ratio of that ETF looks cheap, after paying the two commissions, your actual expense looks more like 2.1 percent, making it no bargain. Many brokers are now advertising commission-free transactions to bring in new customers. However, no-commission trading is not the same as no-cost trading. These brokers often earn a handsome profit from the trading spread and reciprocal trading agreements with other brokerage firms.