The Hidden Rip-off of No-Transaction Fee Mutual Funds

As an Accredited Investment Fiduciary®, one of my duties to clients is to sniff out hidden expenses in investment products to get better investment results for my clients.   All investments incur some expenses – nothing is free.  The trick is in knowing how to uncover the fees you’re being charged, and then determining which fees are worth paying and which ones aren’t.  Any money saved through reduced expenses is money in the pockets of my clients.

Some of the most expensive fees are hidden.  Investment companies would argue that their fees aren’t hidden because they fully disclose them in accordance with regulations, but if you don’t know where to find the information, let alone interpret it, then it’s difficult to make sound investment decisions. 

I’m going to compare the cost of a mutual fund in two different share classes – one “A” share class and one “Institutional” share class, each with their own ticker symbol.  In this example I’m going to use the JP Morgan Value Advantage Fund as an example.  I haven’t used this fund for any of my client accounts - I found it on a national online brokerage firm’s list of “No-Transaction Fee” mutual funds.  Through my research I found an Institutional share class of the same fund was available to professional advisers.  In the table below I compare two key expenses – the annual expense ratio and the transaction fee.  The transaction fee is a one-time charge, but the annual expense ratio is an ongoing expense the investor pays for as long as they hold the fund in their portfolio.

Source: Morningstar, Inc and national online brokerage firm; based on $100,000 purchase 1/8/2014

Source: Morningstar, Inc and national online brokerage firm; based on $100,000 purchase 1/8/2014

An unsophisticated investor would likely find the idea of avoiding a transaction fee appealing, thinking that they’re saving money.  In reality, they’re paying $465.00 more the first year, and $500.00 every year thereafter compared to the institutional share class, assuming the initial $100,000 investment remains flat.  The savings become even greater as the account value grows.

Why does the no-transaction fee fund have a higher annual expense ratio?  Fund companies offer multiple share classes because different distribution channels often have different costs.  The fund company oftentimes must pay the broker to be on their preferred list of retail funds, so they pass on those expenses to the investor by raising the operating expense ratio.  On the other hand, the institutional funds are available only through professional advisors, typically fee-only advisors, so they don’t have to pay a commission nor service the client directly.  In that case, the fund company passes the savings on to investors by lowering the operating expense ratio.  Generally speaking, you want to minimize investment costs wherever you can, but you want to do it smartly.  Being enticed to buy a particular fund simply because it doesn’t incur a transaction fee can actually cost a lot more money than you expected. 

As a fee-only investment adviser our job is to sort through the complex details of investments to find the best value for our clients.   It’s one of the ways we fulfill our Fiduciary Promise.

Gary is an Accredited Investment Fiduciary and CERTIFIED FINANCIAL PLANNER practitioner in Pleasanton, CA.  As fee-only investment advisors, we serve the communities of Pleasanton, Dublin, Blackhawk, Danville, San Ramon, Livermore and the greater San Francisco Bay Area.