Don't Be Fooled by No-Transaction-Fee Funds

Mutual funds charge investors way too much. A $1 billion fund that charges 1% a year — a typical expense ratio — generates $10 million worth of fees. Much of that is pure profit for the fund sponsor.

But fund companies aren't the only ones to blame for outrageously high fees. Also contributing are online brokerages, which generally charge funds 0.40% a year to participate in their no-transaction-fee (NTF) programs.

Most funds pass these hidden charges on to you, the investor. But occasionally you can avoid them. Or you can buy lower-cost funds that charge transaction fees (more on this later).

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Consider DoubleLine Total Return Bond. The institutional share class (symbol DBLTX), which charges annual fees of 0.49%, is available through most online brokerages if you invest at least $5,000 through your IRA. Or you can buy the Class N shares (DLTNX), which are available in NTF programs, for 0.74% annually. (DoubleLine Total Return Bond is a member of the Kiplinger 25.)

The catch? If you want to buy the institutional share class, you have to pay the brokerage a transaction fee, ranging from $7 to $75, depending on the brokerage.

Consider the transaction fee akin to the shipping charge you incur when you buy something online. The pesky fee may be only $3.99, but it sticks out like a sore thumb. Some people may buy the same item at a higher price to enjoy the "free" shipping.

But think about the total cost. If you invest $10,000 in the DoubleLine fund, it'll cost you $49 a year to own the institutional share class. But it'll set you back $74 a year to own the N shares, which are used in no-transaction-fee programs. Assuming you plan to own the fund at least several years, you'll usually do better paying the transaction fee.

"We'd like every dollar possible in the institutional share class," says one fund manager, who declined to be quoted by name. "But you need a no-transaction-fee share class to get traction in this business. Investors would rather pay no transaction fee because they don't do the math."

But it's not that simple. Funds typically impose huge initial minimums on their institutional share classes (funds say they do so at the insistence of the brokerages). If you buy DBLTX in a taxable account, for instance, you'll have to pony up a minimum of $100,000. Most do-it-yourself investors don't have that much to invest in a single bond fund. So most times, investors have no choice but to buy the higher-fee share class.

Many no-load funds sell only one share class. These funds still typically pay the online brokerages 0.40% per year to be in the NTF programs. The brokerages insist that the funds charge the same fees to everyone — even if you invest directly with the fund company. Fund sponsors rarely complain about this arrangement because they get to pocket the entire fee.

Take FPA Crescent (FPACX), one of my favorite funds (and also a member of the Kiplinger 25). The fund charges 1.18% per year, whether you buy it from a broker through its NTF program or you buy it directly from the fund. If you buy it from a broker, FPA pays the brokerage 0.40% per year, or roughly one-third of the entire expense ratio.

Things get even worse when you use a full-service broker. Most full-service brokerages charge funds the same 0.40% that online brokers do. But if a fund sponsor wants to promote its funds to the broker's sales force, the sponsor has to pony up even more to the brokerage.

"These little numbers add up," says Niels Holch, executive director of the Coalition of Mutual Fund Investors, an advocacy group. He estimates that full-service brokerages pocket more than $7 billion annually from mutual fund fees.

What's even worse, the high and varying fees give a full-service broker all kinds of incentives to sell you the fund that will enrich the brokerage the most, rather than you, the investor.

Bear in mind that the full-service brokerage revenues mentioned above are for "no-load funds" — that is, funds that assess no sales charge. Funds that levy loads, or sales charges, add another chunk to the profits of full-service brokerages, as well as increased conflicts of interest.

Fund officials gripe privately about the fees they pay to online and full-service brokerages. But they rarely complain publicly. The reason: Few people invest directly with funds anymore. Most people go through a brokerage. The funds, increasingly, depend on the brokers to stay in business.

But you can fight back. Pay the small transaction fee when you can. Or, as more and more investors are doing, choose low-cost exchange-traded index funds. ETFs pay much lower fees to brokerages, and in some cases you can buy ETFs without paying any brokerage commissions.

It pays to shop around among online brokers. Some brokers offer institutional share classes of individual funds or fund families with low initial minimums. For instance, you can buy the institutional share class of many Pimco funds with just $1,000 at TDAmeritrade.

Many funds refuse to play the brokerages' game. Vanguard, whose funds usually charge investors less than 0.40% annually in total fees, doesn't participate in NTF programs. Some smaller fund companies, such as Longleaf and Dodge & Cox, also stay out of no-fee programs.

Morningstar has found in repeated studies that expense ratios are the best predictor of future returns. That makes sense: The less you pay, the more your money works for you.

Some good funds charge high expenses. FPA Crescent is my Exhibit A. But you'll do best over the long haul if you keep your overall expenses — not a relatively small brokerage commission — uppermost in mind.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

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