Why It Costs So Darn Much to Invest in Mutual Funds

Some brokers charge $4 to make a stock trade. Some charge $7. But the difference largely amounts to a rounding error, an insignificant difference for most investors.

Mutual fund investors aren't so lucky. The same discount brokers that charge very little for stock trades charge as much as $76 just to buy or sell a mutual fund, an exorbitant price to pay, particularly if you plan to add to your investment in small chunks over time.

Why does it cost so much to buy a mutual fund?

In a world where stock commissions are plunging, mutual fund transaction fees have hardly budged, but there are completely logical reasons for it.

First, mutual funds are something most people buy then largely forget about. People don't trade mutual funds like they do stocks, so a mutual fund-only client simply isn't as profitable as the guy who makes 100 stock trades a year. Brokers can make up low prices on stock trades with volume, but mutual funds are rarely bought and sold like stocks are.

Secondly, at the risk of stating the obvious, brokers have to make money for providing a service to you. Without transaction fees, an investor could open a brokerage account to buy all kinds of mutual funds from various managers, making the broker keep all their records while receiving nothing for it. But if the broker can charge $49.95 each time you put money into a mutual fund -- and some do -- then by all means, it's happy to have your business.

Finally, and most importantly, most people probably aren't paying these fees because getting around them is easy to do, so what brokers charge to invest in a mutual fund doesn't really matter. If a broker says it will charge you a fee of $500 a year if you own a pet tiger, but you never plan to have a pet tiger, then the fee for having a pet tiger doesn't really matter. (I'm not aware of any brokers charging a fee for having a pet tiger, just to be clear.)

How you can avoid mutual fund transaction fees

The best way to avoid sky-high mutual fund transaction fees and commissions is to avoid the broker. Mutual funds can be purchased by opening an account directly with the mutual fund company, which doesn't have an incentive to charge you a transaction fee, so going this route is (almost always) a fee-free way to buy a mutual fund.

That means if you want to buy a Fidelity fund, it makes sense to go to Fidelity. Vanguard? Open a Vanguard account. PIMCO? Set sail to PIMCO.com. You get the idea.

But going directly to the fund company isn't the only way to dodge a costly transaction fee or commission. Most brokers also offer a long list of no-transaction fee mutual funds and commission-free exchange-traded funds that you can buy or sell without paying a service charge.

This comes with a little more work. Transaction costs are just one piece of the pie. When looking for alternative funds, you should also compare funds based on their net expense ratios, or what the funds charge in fees to invest in them each year as a percentage of your investment capital.

Getting the best deal

To give you an example of how you might use a different fund to achieve the same objective, consider this scenario: You're a Fidelity customer who really wants to invest in Vanguard's S&P 500 index fund, but you don't want to open a Vanguard account to do it, nor do you want to pay a fee every time you want to add money to it.

You could consider using one of Fidelity's index funds instead to dodge the transaction fees, since it offers its own line of S&P 500 funds without transaction fees. As an alternative, you could invest in the iShares Core S&P 500 ETF, an S&P 500 ETF that is commission-free for Fidelity clients.

iShares and Vanguard's S&P 500 ETFs have the exact same expense ratio of 0.04% of assets, and their historical performance is nearly identical -- both funds track the S&P 500 -- so it would make sense to dodge the transaction fee by using iShares' ETF instead of Vanguard's ETF or mutual fund if you just so happen to already have a Fidelity account.

Of course, it's not always possible to find a copycat fund without a transaction fee. That happens, and sometimes it means biting the bullet and opening an account directly with the fund company you favor. But whether you're looking for boots or brokerage firms, the key thing to remember is that it always pays to shop around. There is no reason to pay a high fee -- or any up-front fee, for that matter -- to buy a fund unless you put a very, very high price on convenience.

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Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.