Some mutual funds are only available for large institutional investors, e.g., pension funds, or to high-net worth individuals through their investment advisors. Because they do not deal with the public (and the higher turnover rate associated with public or “retail” funds due to “emotional” trading), they typically have lower internal costs. They can, therefore, pass those savings on to the investors in what basically amounts to wholesale pricing.

These funds generally have a high minimum initial deposit requirement (usually $1M–5M per investor). They do not charge front-end or back-end fees, and their expense ratios are typically under 0.75%.

It is possible for those with under $1M to invest to buy an institutional fund through a brokerage firm or registered investment advisor. These firms buy into funds as part of a managed mutual fund account for which they charge a management fee.

Some institutional share funds are available through “discount” brokers, though the brokers require the fund to increase its expenses by around 0.25% so the brokerage firm gets paid without charging the investor a transaction fee.

As explained earlier, every mutual fund charges fees to cover expenses and transaction costs, etc. However, because the manner in which a fund charges fees can affect its price, it is important to be mindful of the different “share classes” of mutual funds. The major difference among them is when you pay the fees. Think of them like hotels, where you can be charged upon (or before) check in, or when you check out.

There is also a difference between Retail Funds and Institutional Funds.

Retail Funds
A-Shares. When you buy “A” shares, you pay up front. The up-front fee is usually around 3.5–4.5% of the amount invested, depending on how much you invest. If you buy $100,000 in “A” shares, you’ll pay about $4,000 in up-front fees. As in virtually all other areas of commerce, the more money you spend, the greater the likelihood you’ll enjoy a discount on the fees. In industry parlance, this means that a broker might offer a reduced “front-end load” of 3.5% if you invest $200,000. The fee goes towards the broker and brokerage commissions.

In addition to the front-end load, there are “management fees.” These average 1.0–1.5% of assets managed, and are used to pay operating expenses and the fund manager.

Many “A” share funds also charge an annual 12b-1 fee (named for the section of the Investment Company Act of 1940) that covers marketing and distribution costs.

B-Shares. With “B” shares, there is no front-end fee at the time of deposit. Instead, these funds usually charge higher management fees (typically over 2%). They also charge a back-end fee. This means there’s free admission, but you have to pay to leave. The back-end fee is often discounted or eliminated after a certain period of time (the “surrender period”) to encourage investors to remain in the fund until that period expires, all the while paying the higher management fee.

C-Shares. “C” shares are like “B” shares in that there is no up-front fee and they charge similar management fees. That allows more of your money to grow (hopefully) from the start. But “C” shares generally charge a lower back-end fee of around 1%.

No-Load Funds. No-load funds don’t pay the financial advisor. Instead, the fund charges you, the investor, a fee. That makes them the most transparent of the funds. No need to hunt for commissions and hidden fees since it’s spelled out right up front.

Mutual funds typically do not disclose much information about commissions, yet brokers make a commission on every transaction. One significant problem with commissions is the perverse incentive it creates for advisors who only make money based on transactions to recommend a transaction even if the more prudent course is to do nothing. Equally problematic is the incentive for advisors to upsell products, thereby generating the higher-paying commissions.

To learn about commissions (and some hidden fees), be certain to request a Statement of Additional Information, which mutual funds are required to provide free of charge upon request.

Some disclosures in the Statement of Additional Information will likely come as a surprise. For example, some mutual funds have “soft dollar arrangements” that enables the fund to pay for research costs through the commissions it pays to its broker. By moving research costs to commissions, the fund manager gets to keep a larger portion of the management fee while making the fund’s expenses appear lower.

In 2004, the Wall Street Journal commissioned a study that found that brokerage commissions “can more than double the cost of owning fund shares.” One thing to keep in mind is that fees are not waived or reduced if your account performs poorly. Rather, fees and commissions can compound your losses. If your fees and commissions total 4%, you must earn 4% just to break even – and that’s before accounting for inflation! So, if your money earned a return of 6% in 2014, but your fees totaled 4%, you’d have a net gain of 2%, beating inflation by only 0.4% (and underperforming the S&P 500 by 9.5%). And that’s before those gains are taxed.

Little by little, fees and commissions—whether disclosed or hidden—chip away at that bottom line and can even turn what appears to be a profit into a loss. That doesn’t mean all mutual funds are bad—it just means you have to be savvy when choosing one.

The Turnover Ratio is the percentage of the fund’s holdings that have been sold and replaced with other holdings during the course of the year. A fund with a higher turnover ratio purchases and sells more stocks, bonds, and other financial instruments. The more transactions that a fund engages in, the more fees it incurs.

The turnover ratio is indicative of a fund manager’s investment philosophy. A fund with a high turnover ratio is more likely to be actively managed by a manager who believes he can beat the market. Because using speculation to manage funds is considered a poor investment philosophy, it’s wise to be wary of these funds.

Conversely, a fund with a low turnover rate incurs fewer transaction fees and is more likely to be operated by a fund manager tracking the market. Funds with a low turnover rates also offer significant tax savings. That’s because every time a fund manager sells a stock or bond, he must report the money earned as a taxable gain. These capital gains can be passed on to the fund’s shareholders through higher fees.

A Mutual Fund is a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. These funds may hold over 10,000 stocks and are widely diversified.

Mutual funds are constantly offering new shares for sale to the public. As the Table below indicates, there is an astronomical number of different funds from which to choose.

Investment Options
Total number of stocks 14,089
Total number of mutual funds 30,586
Total number of new funds 54,364
Total number of fund closures 23,778

Data is from the Survivor Bias Free Mutual Fund Database created by the Center for Research in Security Prices (CRSP) as of 12/31/13.

Transaction Costs
Transaction costs are not included in the expense ratio, nor are they disclosed in most prospectuses. They average approximately 1.44% annually. The three most common ones are: brokerage commissions, market impact, and spread cost.

Brokerage Commissions. Brokerage commissions come from mutual fund managers who buy and sell stocks for mutual fund investors in company’s brokerage account(s). Calculating the additional expenses attributable to this “turnover” can be difficult. They can be estimated using information found in the Statement of Additional Information.

Market Impact Costs. Market impact costs are a consequence of the large amounts of trading conducted by such mutual funds. They save on some costs due to the volume of transactions, but the flip side of that is that their large sales or purchases can immediately affect market prices. As a result they end up buying higher or selling lower than they had planned.

Spread Costs. Like market impact costs, spread costs occur when a fund buys and sells stocks. It is essentially the opportunity cost as measured by the difference between the best-quoted ask price and the best-quoted bid price.

Investment Advisor Fees
This fee applies only to those working with fee-based investment advisors who select mutual funds for their clients. Advisors typically charge an annual fee between 0.25% and 2.5% for managing an investor’s portfolio.

Other fees include Commissions, and Sales Load, a one-time fee when you either buy into a fund (Front-End Load) or redeem the shares in a fund (Back-End Load). There are also funds that charge no additional fees (No Load).

A simple way of improving your return on investment is reducing the fees you pay while investing. This is important enough to be an Investment Rule: Reduce your costs.

The only way to reduce your costs is by knowing the cost of every investment you make. Nothing on this Earth is free. Not lunch. Not good advice. Certainly not bad advice. And it’s fair that you should have to pay for guidance on making investments, as long as you’re not being overcharged. You would think that it shouldn’t be hard to figure out if you’re being overcharged, yet fees are often hidden. Some fees are disclosed in an investment’s prospectus, while others can only be found by requesting a Statement of Additional Information from the asset. This is available free upon request.

Over time, these fees can take a tremendous bite out of your investments, even out of your retirement funds. I suppose that’s why so many of them are hidden. Understanding these costs is essential in choosing a fund or deciding whether to remain in a particular fund.

Since some costs are notoriously obscure, I will briefly describe the different fees charged by the most popular investment vehicle: mutual funds.

Fee Disclosed in Prospectus
Expense Ratio: This is the cost of operating a mutual fund, and is often the only cost investors think they are paying when they buy shares of a mutual fund. This fee is typically used to pay marketing costs, distribution costs, and management fees. According to a 2014 Morningstar article, the average open-end mutual funds’ expense ratio has gradually decreased to 1.25% (in 2013), from a peak of 1.47% in 2003. Sadly, this does not represent the total cost of investing in a mutual fund. In truth, it likely only represents one-third of a fund’s costs.

Hidden Fees
These can take some detective work to uncover. Hidden fees are not mentioned in the prospectus, yet they can amount to as much as double the expense ratio. So even if the expense ratio is 1.25%, you could be paying as much as 3.75% in fees and costs! The following are some examples:

Turnover or Trading Costs:
Mutual Funds are compilations of different investments, e.g., stocks, bonds, and cash equivalents. The fund manager, using his best judgment, decides to sell or buy different assets throughout the year. Every transaction, however, incurs transaction fees. Sometimes a fund will trade most or even all of its assets in one year. Because the fund manager does not know in advance how many trades will be made, or even how much each trade costs to make, instead of estimating the anticipated transaction fees in the prospectus, such fees are listed as a “fund turnover” or “trading percentage.”

The Bid/Ask Spread: If you want to sell stock, you don’t typically sell directly to a prospective buyer. Instead, you sell it to a brokerage firm, which then finds a buyer to purchase the stock. Because the stockbroker doesn’t know whether he’ll be able to find a buyer willing to pay more for the stock than the broker paid you, he must offset this risk by paying you less than what he’s hoping to receive when he resells the stock. The more volatile the stock, the lower the price the broker is willing to pay. The Bid/Ask Spread is the difference between what the broker paid you for the stock and what he sells the stock for to the next buyer. It’s similar to a markup you’d pay in a store: the store buys something wholesale then sells it to their customers at a marked-up retail price.

One important piece of information to share with your investment advisor is how much time you have to invest in order to achieve your goal. This is all part of having open and honest conversation with the person who will invest your money.

If you’re young and have a long time horizon before you need funds to buy a house or for some other expensive purchase, you may find that an aggressive portfolio is right for you. A young person’s portfolio can be 100% stock-focused—that is, it is totally focused on growth. That may sound very risky, but it is a good hedge against inflation. (A 100%-stock portfolio can still be well diversified by varying the asset classes of the stocks.) In addition to minimizing inflation risk, an aggressive portfolio gives you the best chance of higher returns in exchange for higher market risk and volatility.

A 100%-stock portfolio should have a time horizon of at least 10 years to weather downturns in the market. In the worst case scenario, $100,000 invested in stocks would still be worth at least $100,000 10 years later. You would not be pleased with this outcome, nor would I, and while it is possible, it is probably the worst case scenario even though it’s the riskiest form of allocation. Remember the Investor’s Dilemma? In these circumstances, the key is to continue to hold.

At the opposite extreme is retirement money. You’re not going to spend all of it 10 years, six–nine years, three–five years, or one–three years; it must last the rest of your life. For this investor, the goal is to generate a stable income for the rest of your life. Investing for that goal generally involves a portfolio with 50–70% stocks and the rest in fixed income. Many of my clients use a 60% stocks and 40% fixed income mix, which is a very traditional pension mix.

This list continues ranking assets from least risky (T-bills and bonds) to most risky (U.S. and International Value Stocks).

Large Stocks: U.S. and International: Large U.S. Stocks make up a disproportionate share of Americans’ portfolios. That is partly for marketing reasons, and partly because people tend to invest in what is familiar or what they hear about. People are often surprised to learn that Large U.S. Socks went through two 20-year periods during the last century when they offered no returns after inflation (1929 to the mid-1950’s, and 1966–1982). Even if these stocks feel like a safe bet, it’s risky to have all of your money in this area of the market.

From 1973–2013, the annualized return on Large U.S. Stocks was 10.27%. Large International Stocks’ annualized return was 9.51%. The returns are very similar in the long run, but most people feel more comfortable investing U.S. companies, without realizing that large corporations sometimes change their citizenship. For example, Anheuser-Busch, the largest brewery in the U.S., has been headquartered in Belgium since InBev acquired it in 2008. Similarly, in 2015, U.S. Pharmaceutical giant Pfizer announced plans to merge into Allergan, an Irish company.

The point is that globalization of industry has eliminated some of the distinctions between domestic and foreign-based corporations. We don’t think very differently about Hershey chocolate in the U.S. versus Nestlé chocolate in Switzerland. They’re both big, well-known, publicly traded companies in a competitive market. And over time, both U.S. and International Large Stocks tend to provide higher returns than bonds. Of course, with that higher return also comes a higher degree of volatility, e.g., risk.

Small Stocks: U.S. and International: We see similar performance in Small U.S. Stocks and Small International Stocks. (Their names will likely be unfamiliar to you. The Russell 2000 is the benchmark index for Small U.S. Stocks. The portion of the portfolio focused on these stocks aims to match the returns of the Russell 2000.) Over a 30-year period, Small U.S. Stocks and Small International Stocks have had similar returns: 12.92% and 13.39%, respectively. While you might think Small International Stocks would carry a much higher risk than Small U.S. Stocks, the research shows that adding this asset class to a portfolio actually reduces overall risk, because circumstances affecting stocks in the U.S. are usually not the same circumstances affecting international stocks. In late 2001 and early 2002, Small International Stocks were the ones that resisted the market downturn that affected the U.S.

Value Stocks: U.S. and International: Value stocks are shares of companies that have lower market prices than comparable companies of a similar size. This is usually due to lower-than-expected earnings and/or some underlying distress. As a result, they are a riskier investment, but they carry the potential for some of the highest returns if the company is able to right the ship.

There is risk and reward inherent in distressed companies. Investors are less willing to buy into the stock given the level of risk involved, so the price drops. This builds the degree of risk into the price, as per the Efficient Market Hypothesis.

But asset class is not the only basis of the investment decision. Another important factor to consider is your time horizon. The more time you have, the more risk you may be comfortable taking on since you can wait out economic cycles and downturns. In contrast, if you expect to need the money within five years—for example, to finance a child’s college education—the shorter time horizon would make less risky investments more appropriate.

Over time, you will typically make more money from stocks than from bonds.

There are numerous types of investment vehicles, or assets, available to you. Assets are economic resources. Each asset class theoretically has the same overall goal—to make money over time—yet each serves a different function in terms of risk and reward. Let’s review the most popular ones starting with Treasury Bills and Bonds. (They asset class in this discussion and the next one are listed from the lowest- to the highest-risk investments.)

Treasury Bills: Treasury Bills, or “T-Bills,” are the instrument the U.S. government uses to borrow money for less than one year. Safety is the key function of T-Bills, because they have never gone down in value. These days, however, T-Bills don’t go up much in value, either. Since they mature in less than one year, the risk of interest rate changes is minimal. Depending on how you calculate it, the rate of return is typically around 0.9% above the rate of inflation. That’s not much of a return, but that’s not the purpose of T-Bills; the purpose is safety. If your risk tolerance is low (e.g., upon retirement), it is appropriate to move more of your money into this asset class.

Long-Term Treasury Bonds: “T-Bonds” provide a slight increase in return in exchange for a longer maturity period – typically ten–30 years. In December 2015, the T-Bond rate was 4.615%. In December 2001, the rate was 8.283%. Over the past 30 years, the interest rate for T-Bonds has remained roughly in the range of 3–9%.

Bonds are in your portfolio to provide safety. Long-term bonds tend to go up when the stock market goes down because of what is called a “flight to quality.” When people panic, they buy what they believe is stable, and safe: U.S. government bonds. Why? The government can tax and print money, and will not go bankrupt. Investors can feel comfortable that they will get their money back. As the demand for bonds goes up, so does their value. But they still carry some risk.

Between the 1920s and the 1980s, interest rates rose, but ever since then they have declined. In 2009, the trading value of T-Bonds dropped an average of 14.9%. Indeed, from 2010 through 2015, short-term interest rates were at the lowest possible rate – 0.25% – with two-year bonds also returning less than 1% during this period. Although T-Bonds recently received a nominal bump up to 0.5%, current interest rates remain essentially at 60-year lows.

In 2002, when the stock market went down 22%, intermediate-term bonds (those maturing in three–ten years) experienced a 16% return. That’s even better than it looks, because these intermediate-term bonds went up 16% up when Large U.S. Stocks went down 22%. In 2008, when Large U.S. Stocks went down around 40%, intermediate-term bonds rose 13%. That is the purpose of bonds in your portfolio: they provide safety just when you need it most.

Fixed Income: Fixed income investments are typically municipal bonds or treasuries that pay a predictable premium on a regular schedule.