At first glance, the cost of investing in a mutual fund seems straightforward. The net asset value (NAV) is the price of each share. For example, the NAV of the Neuberger Berman Focus fund (NBSSX) is currently $25.45. That's what one share costs — or is it?

A look at the fund's prospectus reveals an "expense ratio" of 0.98%. That indicates the total amount a shareholder will pay annually to help cover the fund's operating and marketing expenses. For every $1,000 invested in the fund, $9.80 will go toward these expenses on an annualized basis.

  • Operating expenses
    All funds cover their operating expenses out of the money that shareholders invest. The largest such expense is typically the fund's "management fee," which pays the salaries of the portfolio managers and any supporting staff (financial analysts, etc.). Other operating expenses include the costs of having an office and equipment, additional staff, and the fees paid to a bank to maintain shareholder accounts and safeguard all the money and securities constantly coming and going. Last are the costs of presenting regular reports to shareholders, and obtaining legal and auditing services.
  • Marketing expenses
    Many funds pay their marketing expenses out of the management fees they collect. But others add a separate item called a 12b-1 fee, named after the SEC ruling that permits it. This money is used to promote the fund to prospective investors — typically by paying distribution fees to brokers or brokerages. Schwab, for example, charges 0.40% of a fund's assets annually for a fund to be listed as a "no-transaction-fee" offering on Schwab's platform. It's not difficult to understand why some funds recoup a portion of those costs by adding a 12b-1 fee. (The maximum allowed is 1.00%.)

All of the operating and marketing expenses are included in a fund's expense ratio. But these operating and marketing expenses aren't paid all at once. Rather, in a manner invisible to the shareholder, a small portion is subtracted daily from the fund's net asset value. The NAV a fund reports each day has already had that day's share of the annual costs deducted. (SMI's performance momentum scores, as a result, already account for the impact of each fund's varying levels of expenses.)

The chart at right shows the impact of these fees on a $10,000 mutual fund investment that would have gained 8% each year if no expenses were taken out.

Note that fund returns are never reported this way — all published returns are always reported after expenses have already been deducted. This makes it easy for investors to simply compare the stated returns for one fund against any other fund without having to make any further adjustments for expenses. But we wanted to illustrate the impact of all the various types of fees, so we're starting this example from this before-expenses vantage point.

The first column shows a fund that charges, as all funds do, a fee for its operating expenses. If there were no fees whatsoever, a $10,000 investment that earns 8% would be worth $10,800 after one year. However, since the fund charged 1.00% to cover its operating expenses, the amount grew to $10,700 instead. (Just to be perfectly clear, this fund's published return would be 7%, not 8%.)

The second column shows the impact on the fund's return if it also charged a 0.23% 12b-1 fee to help cover its marketing costs. Now, instead of 1.00%, the total expense ratio is 1.23%, further reducing the shareholder's balance to $10,677.

  • Sales loads
    So far, we've been looking at no-load funds, those that are sold without sales charges. No-load funds charge fees to cover their costs, but they don't make investors pay a salesperson's commission.

    No-load funds deal directly with investors without having a sales force represent them. They count on investors being willing to do their own research and paperwork (or rely on a trustworthy investment newsletter for recommendations as to which funds to buy and sell!) and not needing a broker to recommend which funds to buy. The third column shows how much can be saved by avoiding funds that charge a front-end load.

    Brokers and some financial planners get paid for their advice by earning commissions from the funds they steer money into. Those charging a front-end load (a commission that is paid right away from the amount you invest) are most commonly called "Class A" funds.

    In contrast to the up-front loads of A-shares, "Class C" shares compensate brokers by charging higher expenses (some of which is returned to the broker as an ongoing quarterly fee) and a back-end sales charge. At a glance, these funds seem almost like no-load funds. Their deferred load is typically a relatively small 1%, and usually only applies to redemptions made during the first year an investor owns the shares.

    You can see that, under similar market conditions, C-shares start off with a significant advantage over A-shares, due to avoiding the upfront commission. The table reflects the most common front-end load of 5.75% and the average expenses of each share class, revealing that the typical C-share is a better deal for several years after purchase. Only if a fund is held many years does the A-share eventually become a better deal due to its lower annual expenses (circled in the table).

    SMI's Upgrading strategy never recommends A-shares and only occasionally recommends C-shares. As the table shows, no-load funds have such a tremendous cost advantage that it takes an exceptional load fund to overcome the structural overhang of those higher fees and commissions.

Avoiding class confusion

Many mutual funds have multiple share classes available. These differing classes of the same fund are invested the same way, but are either sold differently (through a salesperson or not), or are designed for different groups of investors (individual investors vs. institutional investors). Each class may require a different minimum investment amount and will likely have varying expense ratios.

In addition to load funds, which typically come in at least A- and C-shares, many no-load fund companies also offer multiple classes of their funds, usually charging lower expenses for those with larger sums to invest.

For example, Vanguard offers some of its funds in both "Investor" and "Admiral" share classes. The Vanguard 500 Index Fund (VFINX) Investor shares charge an expense ratio of .17% and require a minimum investment of $3,000. The Admiral shares of the same fund have a lower expense ratio of .05%, but require a minimum investment of $10,000. For institutional investors, Vanguard offers some funds with even lower expense ratios, but the minimum account balance requirements are much higher. Fidelity offers similar distinctions on some of its funds (typically index funds), labeling them "Investor," "Advantage," and "Institutional" share classes. Schwab offers only retail vs. institutional shares.

  • Transaction fees 
    Just because an investor avoids paying a commission by steering clear of load funds doesn't mean he or she will never have to pay to buy or sell a fund. Many brokerages charge transaction fees for some no-load funds. That's why SMI indicates whether each recommended fund is NTF (no transaction fee) or not. Be aware, though, that SMI research indicates investors have been better off buying recommended funds even though those funds have transaction fees rather than avoiding them because of the fees.

    As if the share class/transaction fee discussions aren't complex enough, some brokers offer both a transaction fee and no-transaction-fee (NTF) version of the same fund! Typically this occurs when a fund offers a second class with higher ongoing expenses (perhaps by adding a 12b-1 fee) that help offset the cost of making the share class available NTF. SMI calls attention to this when recommending a fund by footnoting it and listing the alternate ticker symbol. In general, the larger the sum of money you are investing and the longer you expect to keep it invested, the more it usually makes sense to pay the transaction fee in return for the lower expense ratio, and vice versa.

Clearly, understanding the true costs of buying and owning a mutual fund requires looking beyond its NAV. While it's smart to steer clear of the most obvious fees, such as front-end loads, it's also important to make fund performance a higher priority than fee avoidance.