Ask a Fool: How Do Mutual Funds Make Their Money?

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Q: How do mutual funds make their money?

A mutual fund is essentially a pool of investors' money that is professionally invested on their behalf, so there are naturally some expenses involved. There are two basic types of mutual fund expenses, one of which you can avoid, and one that you'll always have to pay.

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The first is known as a sales charge or "load." These are commissions paid to third parties such as financial advisors or brokers, and can be charged when you buy the fund (a front-end load) or when you sell (a back-end load). These have become increasingly unpopular in recent years, and by limiting your search to "no load" mutual funds, you can avoid this entirely.

On the other hand, all mutual funds have an ongoing charge known as an expense ratio. This is the fund's annual operating expenses -- such as the managers' salaries, office expenses, etc. -- and is expressed as a percentage of assets under management. In other words, if you have $10,000 invested in a mutual fund with a 1% expense ratio, you'll pay $100 in fees this year.

You may see two different expense ratios listed for a particular fund: gross and net. A gross expense ratio is the fund's total operating costs, while the net expense ratio reflects the current amount being charged and may include temporary discounts. Pay more attention to the gross expense ratio, as it tells you how much you could end up paying.

As a final point, it's important to realize that fees vary widely among different funds, so shop around. A seemingly small savings in fees can make a big difference in your long-term investment returns.

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