How Mutual Fund Companies Make Money: Explained
How Mutual Funds Work
A mutual fund is a professionally managed fund that pools investors’ cash. To invest in a mutual fund, an investor buys shares, which represent a portion of the ownership of the fund’s assets. The fund manager uses investors’ cash to buy securities that make up the fund’s portfolio.
Mutual funds can be actively or passively managed. When a fund is actively managed, the fund manager buys and sells holdings at their discretion, while passive management means that fund managers attempt to replicate the performance of an index, such as the S&P 500.
How investors make money with mutual funds
Investors can earn money from mutual funds in several ways, which mainly depend on the type of mutual fund held by the investor. The three different ways investors make money from mutual funds are through price appreciation, dividends, and interest payments.
- Price assessment: Investors can earn money through appreciation in the value of the fund’s portfolio.
- Dividends: Investors can earn money from dividends received by the fund, which are either distributed in cash to the investor or reinvested in shares of the fund, at the option of the investor.
- Interest payments: Interest paid to the fund may come from coupon payments on bond holdings or cash equivalents held by the fund.
How Mutual Fund Companies Make Money Themselves
Mutual fund companies make money primarily in two ways:
- By management fees for the organization, operation and management of the fund; and
- Through sales charges to investors when buying or redeeming shares.
Mutual funds are for-profit corporations. They invest on behalf of public investors as a business designed to make money for themselves and their own investors or owners. They do this by charging a fee against the assets of the fund to cover their expenses of managing the fund and making a profit.
The charges are deducted monthly or quarterly from the assets of the fund and are collectively referred to as the annual expense ratio. The expense ratio typically ranges from 0.5% to 1.0% per year, so that, for example, if an expense ratio were 1.0%, it would cost an investor $10 per year for each $1,000 of fund assets.
In addition to management fees, funds are permitted to charge separate marketing and distribution fees known as 12b-1 fees. These fees are capped at 1.00% annually and are frequently used to compensate internal or external sellers of the fund when funds are offered with little or no sales charge.
Mutual fund sales charges
Mutual funds are distributed to investors through brokers, advisers or other licensed sales agents and are therefore subject to sales charges for the purchase or redemption of shares. Mutual fund sales “charges” can be up to 5.75% and can be applied to purchases (sales charge) or redemptions (exit charge). In all cases, they are used to remunerate a sales intermediary and are subtracted from an investor’s assets when entering or exiting the fund.
Sales charges can vary widely, depending on the class of shares the investor owns or purchases, the amount of capital involved, and the length of time the investor has held the shares. Some funds or share classes may have little or no sales charge, but are likely to have higher 12b-1 fees charged each year instead.
Some brokers have special mutual fund programs that allow investors to buy and sell shares of many different funds on one platform. These programs may charge a flat fee, regardless of the number of shares, up to $49.95 per trade. These fees are collected by the broker rather than the fund company and are therefore charged separately rather than deducted from the fund’s assets.
Point: Sales and transaction costs can vary significantly between funds and share classes. Additionally, funds with lower sales charges may have higher 12b-1 annual fees. Accordingly, it is incumbent on investors to be diligent in researching the fees and sales charges associated with various funds and to explore options that will be more favorable to their circumstances.
How brokers make money with mutual funds
Sales agents or intermediaries, such as broker-dealers or commission-based financial planners and advisers, may earn money from mutual funds through sales charges or commissions, or 12b-1 fees .
Mutual funds make money for fund shareholders through price appreciation of the underlying assets, as well as by receiving dividend and interest payments on those assets. Investors in shares/units of the mutual fund benefit proportionately. Mutual fund companies themselves, as well as intermediaries such as brokers, investment advisers and financial planners, collect fees from mutual fund investors. It is important for investors to learn about mutual fund costs before investing.