When you’re in the market for a mutual fund, finding a fund with the lowest overhead is always a good idea. Selecting a no-load fund is a smart move because you will avoid fees incurred when stocks are bought and sold within the fund. There are, however, other fees and costs related to owning a mutual fund that you cannot sidestep, and understanding the true costs of owning a mutual fund is important so that you can calculate exactly how much your real return on investment will be.
When buying a mutual fund, you may encounter three types of transaction costs. You may pay brokerage commissions, a spread cost, and market impact costs. The amount of each cost is difficult to predict, so asking a financial professional about which of these costs your fund may have associated with it is a shrewd move before you buy.
A mutual fund’s expense ratio is a more well-known cost, because this fee is used to pay for the fund’s management and other costs incurred for marketing and distribution. It’s a continuous cost, and you can figure out what the amount will be for the fund you choose by reading the prospectus.
The cash drag of a mutual fund is the amount of money that a fund manager must hold aside to keep the fund liquid to purchase stocks. It’s also used to pay off fund investors who choose to cash out. This puts a major dent in a fund’s performance if the stocks in the fund become more valuable and the amount is greater than the cash the fund manager has held back. Cash drag affects people who buy mutual funds for the long term, because the amount of cash held back could be used for more stocks in the fund, but instead, it is being kept aside for investors who may choose to cash out more quickly.
As with all financial instruments, taxes are a necessary evil and a cost that must be factored in when selecting a mutual fund. If you buy a mutual fund that contains stocks that have already increased in value, then you run the risk of being subjected to capital gains taxes for these stocks. Therefore, you should speak with a tax professional prior to purchasing a mutual fund to determine whether you will need to pay these taxes, and what the cost will be in relation to your potential returns.