Pop quiz: If someone wanted to charge you more than $600 for something you could get for less than $10 somewhere else, who would you buy it from? Most of the time, that answer's a no-brainer.
But for some reason, when people buy mutual funds, they often end up paying the $600 price instead of the $10 one. And the worst part is that the investments they get are more or less identical -- except for that upfront markup.
The Alphabet Soup of Mutual Funds
If you buy mutual funds from a broker, you'll usually get a menu of fund choices to pick from. You'll be able to choose from different types of investments like stocks, bonds, and commodities, with many subcategories available for each.
But even once you pick a certain fund, your broker may still have another choice for you to make. Choosing the right "class" of fund shares should be as simple as ABC, but the fine print hides some expensive propositions. Here's a cheat sheet:
So-called "A shares" make you pay a sales charge up front. Your broker receives those charges, which often run between 3% and 5.5% of the amount you invest.
*B shares" let you avoid the upfront charge, but if you sell within a certain period of time, you have to forfeit a similar amount from your sales proceeds. In addition, you'll often pay a higher annual expense fee.
"C shares" get rid of both the upfront and back-end sales charges. In exchange, though, you agree to pay around 1% of your total investment each and every year.
Which type of fund shares give you the best deal depends on your investment style. If you plan to hold onto your fund shares for decades, then paying an upfront fee will cost you less in the long run than an annual charge. But if you're only in the market for the short run, then paying a few years of 1% charges could cost you less.
Why Pay More?
When you're shopping, paying more generally gets you better-quality merchandise. But with mutual funds, you often don't get what you pay for.
For instance, one of the simplest investments you can buy is a fund that simply owns every stock in the market. These "index funds" track the market almost perfectly. And the best benefit of index funds is that you can buy them on the cheap. For instance, if you invest $10,000 in the Vanguard 500 Index Admiral Fund, you'll pay only $6 per year in fees.
But if you go through your broker, you might end up with a much more expensive version of the same fund. Invesco S&P 500 Index A, for example, charges more than $60 per year on a $10,000 investment. Even worse, with a load of up to 5.5%, you could end up losing $550 of your investment to upfront sales charges.
Save Your Money
The SEC has looked into putting limits on the fees on mutual funds, especially the ongoing 1% annual fee that most C-shares charge. Brokers and the mutual fund companies whose products are broker favorites have argued that they incur marketing and sales expenses that these fees are designed to recoup, and that putting limits on their ability to collect those fees would only result in investors having fewer choices about how they invest.
The better solution for most people, however, is to avoid mutual funds that charge these fees in the first place. Financial professionals deserve compensation for their work, but you'll often be better served getting paid advice at a flat rate rather than paying a big percentage of your investment. With so many low-cost alternatives available, you can't afford not to do a little legwork. Doing so could save you a bundle.