 Welcome to the session. This is Professor Farhad in which we would look at the cost of investing in mutual funds. This topic is covered in an essentials or principle of investments, whether graduate or undergraduate. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lectures, please like them, share them, put them in playlists. If they benefit you, it means they might benefit other people, share the wealth, and connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources, whether you are studying for your finance courses or accounting courses, studying for your CPA, CFA, or CMA exam. I strongly suggest you check out my website. So before we talk about the expenses associated with buying mutual funds, we want to know how mutual funds are sold? Well, mutual funds are sold directly, basically from the fund underwriter. The underwriter is the person that create the fund. They can sell it to you directly. They can sell it to you through mail, their offices, over the phone, or over the internet. Most of the time, you buy funds usually over the internet, and if you have a broker, you can buy through the broker. Investor can contact the fund directly to purchase the shares, and usually you do so through the internet. You can also buy them indirectly through what's called sales force, and who are the sales force? Basically, we're talking here about brokers or financial advisors. And those people, they receive a commission for selling you shares. Now, we're going to talk about the commission shortly about what type of commission you get charged for buying a mutual fund. But you have to keep in mind, when you buy it indirectly, there could be a potential conflict of interest because the broker or the financial advisor may not be recommending the best fund for you. Why not? Because they might be getting a fee, and if that fee is higher for them, they may recommend the fund that generate more fees for them to just be careful about that. The best way is to read the prospectus and determine if that's a good investment for you or not. Also, mutual fund can be sold through financial supermarkets like banks, insurance company that can sell shares of many different funds. So those are the three ways that you can buy a mutual fund. Now, it's very important to understand the fee structure of a fund. How are you going to be charged? Because a fee is important. When you are charged a fee, that's going to lower your return. So it's very important to understand the different type of fees. Okay? So an individual investor choosing a mutual fund should consider not only the fund-stated investment policy and past performance, especially past performance doesn't indicate future performance, but also fees and other expenses. Because what matters is, what is my return at the end of the day? Now, what can you learn about mutual fund? You can go to something called a Morgan Star mutual fund source book, and it will show you the different types of funds. You can find it in your public library. You should also be aware of four general classes of fees when it comes to mutual funds. Operating expenses, front-end load, back-end load, and 12B-1 fees or charges. I'm going to be talking about each one of those separately. Let's start with operating expenses. From the word operating expenses, it's cost incurred to operate the portfolio. And what type of cost do we have to operate this portfolio? Well, maybe administrative cost, maybe advisory fees, pay to investment managers. And these costs generally ranges from 0.2 to 1.5% of the asset's under management. So this is usually, so there's no dollar amount that's usually a percentage of the dollar amount. And those expenses are periodically deducted from the asset of the fund, so they don't send you a bill for those expenses. Simply put, they will take it from the fund. They will deduct it from the fund. And just to give you an idea, the simple average of the expense ratio of all equity funds in the US was 1.82 and 2016. Now, the average expense differ between the different type of funds. For example, if you are dealing with index fund, index fund means you're following a specific index, so you're not really active. It's as low as 0.09. If it's an active fund, it could ranges in the 0.82. Obviously, active is more expensive than basically index fund is passive. You buy the shares and you don't do any research. You don't have any research because just following the S&P 500 or the NASDAQ 100 versus an active fund, you have to do research, buy, and sell. Also, in addition to those operating expenses, most fund assessor fee for marketing and distribution, distribution costs. They use primarily those to pay the broker or the financial advisors who sell the funds. So investors can avoid these expenses by buying shares directly from the fund sponsor. But many investors are willing to incur these distribution in return for advice. So that's what you're paying for really. So those are the operating expenses. You could also have what's called front-end load. And what's a front-end load? It's when you buy the mutual fund, there is a fee up front. So commission or sales when you purchase the shares. It's a front-end when you enter your position. These charges, which are primarily used to pay the broker who sell the funds, may not exceed 8.5. But in practice, they range no higher than 6%. And that's pretty expensive. I don't like front-end load because they take their money up front and that's personal preference. I know my friend, he uses front-end load mutual fund. That's fine. It's your preference. There's low-load funds, have loads ranges up to 3% of invested funds. So there's low-load, regular front-load could be up to 6%. And there's no load funds that have no front-end sales charge. No load. That means I don't charge you anything by entering the position. And about half of all funds have no load. Basically, you don't pay anything up front. Basically, load effectively, and this is important, reduce the amount invested. So if you invested $100,000 and there's a 5% front-end load, that's, they will take away 5,000 and you're starting your investment at 95,000. So you want to make sure you're aware of this. For example, each $1,000 paid for a fund with a 6% load in sales charges, which is it means they're going to take away $60, you are left with 940. Now to go back up to $1,000, the fund will have to earn 6.4%. To go up from 940 back to your original investment. So simply put, the first 6.4% of the cumulative return is the fee paid to the broker. That's the front-end. We also have what's called a back-end load. Back-end load, you pay it when you're exiting your position, when you're selling your position. It's a redemption or an exit fee when you sell the shares. These typically fund that impose this, they will start at 5% or 6%. And what happens every year you keep your fund, they would reduce it. For example, if you wait two years, the six becomes four. If you eat another year, it becomes three, so on and so forth. So they'll give you an incentive to keep the money with them, to keep the money with them. So an exit fee that started at six would fall to four by the start of the third year. These charges are formally known as contingent the third sales load. That means contingent based on your exit. In other words, they want to encourage you to keep your money with them as long as possible. Therefore, your fee will go down when you sell. We also have what's called 12B1 fees or charges. That's an annual charge. Notice this is an annual charge by the mutual fund to pay for marketing, usually for the broker and distribution costs for annual report and prospectus. So those 12B-1 fees are named after the SEC rule that permit the use of these plans. So this is basically here, we're talking about something related to the SEC. That's the fee. So here's what's going to happen. Those funds may use the annual 12B charges in addition or instead. So it could be in addition to the front-end loads. So they will charge you an upfront fee and they will charge you an annual fee. And the reason is to generate fees to pay for the broker. Now also, as with operating fees and all other fees, they are not, you're not explicitly billed. They'll simply, they will take the money from the fund. They will deduct the money from the fund, just like with the or the other fund. So 12B1, if any, must be added to operating expenses to obtain the true annual expense ratio. So you have to make sure when you're looking at your mutual fund performance, what matters is after all the expenses. So 12B-1, you have to deduct them, just like you have to deduct the front-end if there's any back-end operating expenses, so on and so forth. So the SEC require all funds to include in the perspective a consolidated expense table that summarizes all the relevant fees. So when you look at your prospectus, you should know and it should be pretty straightforward and being able to read those funds, to read those expenses. Usually, they're limited to 12B-1 to 1% of the funds average net asset per year. So asset minus expenses, you will take out 1%. So how do we measure the return on the portfolio? Well, it's the measure of the difference between the beginning of the period and the end of the period. Hopefully, it's an increase, not a decrease. That's one factor of the return plus any income distribution such as dividend or distribution of capital gain expressed as a fraction of net asset value at the beginning of the year. So simply put, when you buy a mutual fund, you buy it at a certain price, you look at the end of the year. If the price is higher, that's part of your return and if they gave you any money or dividend or distribution, that's also part of your return. So if we donate the net asset value at the start of the period as NAV0 and NAV1 at the end of the period, this is how we measure the return. So NAV1, the end of the period minus the beginning of the period plus any income and capital gain distribution divided by the original cost NAV0. So let's take a look at an example. If we're looking at an NAV at the start as $20 makes an income distribution of 15 pennies and a capital gain distribution of five pennies and it end up to be $20.10. So how do we measure the monthly return? Look, the difference in the price, the difference in the price is 10 pennies plus, plus you earned 0.05 in capital gain distribution plus 15 pennies in distribution and you invested $20 NAV0. All in all, this is going to give us 1.5 percent return, 1.5 percent. So again, this is your 10 pennies, the difference in the beginning. So this is you made 10 pennies on the price of the mutual fund, you add to it the income distribution, the capital gain divided by the original price, you'll get 1.5 percent. So let's take a look at expenses and how do expenses affect the rate of return? Obviously, how do they affect it? It will bring it down, obviously. So let's assume a fund with $100 million an asset at the beginning of the year with 10 million shares outstanding. The fund invests in a portfolio of stocks that provide no income but increases by value of 10 percent. The expense ratio, including the 12B-1 fees is 1 percent. So the expense, everything is 1 percent. What is the rate of return for an investor and the fund? Well, the initial NAV, you'll take 100 million divided by 10 million shares you are buying an NAV of $10. That's your original cost. In the absence of the expenses, what's going to happen, the fund will go up to 110 million and the NAV will become $11. So you bought something at 10, it went up to 11, okay, which is a rate of return 1 divided by 10. It gives you a rate of return of 10 percent. But what's going to happen is the fund, it's going to take 1 percent. The expense ratio of the fund is 1 percent. Therefore, $1 million will be deducted, leaving the portfolio with 109 million. Therefore, the NAV, if we compute, if we take 109 million divided by 10 million shares, the NAV is $10.90. It went down. Therefore, if we take 90 pennies divided by 10 dollars, your rate of return is 10 percent. Simply put, the expenses ate up 1 percent of your return and that's a lot of money. If you have the equity fund sells class A shares with no front-end, with a front-end load of 4 percent. So there's a front-end load of 4 percent and class B shares with 12.1, 12B-1 fees of 0.5 percent as well as a back-end load fees. Remember, back-end is when you exit starting at 5 and falls by 1 percent after each year as the investor holds the portfolio until the fifth year. So simply put, if you wait 5 years, you can cash out and you will not have any back-end load fees. That's the key. Assume the return on this fund portfolio is net of operating expenses is 10 percent. What will the value of 10 percent investment in class A and class B shares after 1 year, 4 years and 10 years? So this is just an exercise to show you what happened over the years with different fee structures. So which fee structure provide higher net proceeds at the end of each investment horizon? That's what we're looking for. So simply put, A, the net investment in class A shares after the 4 percent commission you are starting for at 9600. If we earn 10 percent, simply put, we're going to take 10,000, 9600 times 1 plus the interest rate raised to the end power, end power 1, 2, 3, 4, 5, all the way till 10. So this is how we find the return for class A. For class B, the shares has no front-end load. However, the net return to the investor after 12 V-1 fees will be only 9.5. Why? Because there is 10 percent minus 0.5, therefore, 9.5. But remember, starting year 1, year 2, year 3, you still have to deduct. After year 1, you have to deduct 4 percent. After year 2, 3 percent. So also you have to reduce your percentage until year 5. So let's take a look at the actual numbers and see what it looks like. So after a year, class A will take 9,600 times 1 plus the interest rate raised to the end power. Hopefully, you know this formula from your principles of finance. So after one year, your return is 10,560. For class B, you have 10,000 times the rate of return is 9.5 because they take 0.5 for the 12 B-1 fee times you're going to keep only 96 percent because there is a 4 percent back-end fee. So your return is 10,512. So notice in the short horizon, A is doing better one year. In the medium horizon, which is four years later, the return for class A is $14,555. For class B, we'll take 10,000 times again, 1.95 raised to the fourth power. Now you are keeping 99 percent because this is the last time the last theory are responsible for any back-end fee. Therefore, in the medium horizon, if you sell now, you will do better than class A because you will get $14,232. Remember, starting in year 5, there's no back-end for class B. But also, after year 5, what happened is class A would recover that 4 percent that they paid up front. So when we get to year 10, notice class A will have $24,000, almost $900, $24,900. For B, you will take 10,000 times again, 9.5. There's no more back-end fee, but you're still paying this 0.5. Class A going forward don't have to worry about any fees anymore, but you are paying that repeated fees. Therefore, you will get $24,782. You may not think that's a big difference, but if you add zeros to these numbers, millions, if these numbers are in millions, then it makes a huge difference. You're talking millions of dollars difference in return. Therefore, you can see in the short horizon, medium horizon, and long-term horizon, which one does better in the long-term horizon, 10 years or more, class A will do better. So it's very important that you understand how the fee is structured for your portfolio. And also what's important when you invest in a mutual fund is the taxation aspect. Because guess what? After you make your profit, here comes Uncle Sam, give me a share of it. So you want to understand how taxation work because your true return, your true return is after taxes. This is what matters to you as an investor. Not what they're quoting you. It's how much am I going to get after my operating expenses, 12B-1 in my taxation. So in the next session, we'd look at the taxation aspect of mutual fund. Again, if you like this recording, please like it and share it, put it in playlist. Don't forget to visit my website, foreheadlectures.com, if you are looking for additional resources to succeed in this course. Good luck, study hard, and stay safe.