How Does Mutual Funds Make Money? Business Model Explained!

Investors are familiar with mutual funds, but relatively few know how they actually work. Most people are not financial experts, and they have more pressing concerns than the structure of fund companies. 

This isn’t surprising; after all, most people are not experts in finance. It would help some investors to understand that mutual fund companies make money from their fees and that fees vary from one fund to the next. Investors pay mutual funds a percentage of assets under management (AUM) to make money through sales charges, which work like commissions.

A fund company’s prospectus must disclose shareholder fees and operating expenses to the Securities and Exchange Commission (SEC). Investors can find this information in the prospectus fee table. 

Generally, mutual fund companies earn most of their revenue through fees, although some companies may make investments on their own. In addition to purchasing fees, sales charges, and mutual fund loads, there are deferred sales charges, redemption fees, account fees, and exchange fees.

How Do Mutual Funds Work?

Thanks to their combination of flexibility, low cost, and potential for high returns, mutual funds are among the most popular and successful investment vehicles. An investment in a mutual fund differs from putting money into a savings account or a certificate of deposit (CD) at a bank. You are actually buying stock in a company when you invest in a mutual fund.

It is an investment firm that you are buying. Investing in securities is the business of mutual funds, just as Ford manufactures cars. Mutual funds may have different assets, but their ultimate goal is to make money for shareholders.

Three ways exist for shareholders to make money. Firstly, you will receive a return from the interest and dividends paid on the underlying holdings of the fund. In addition, investors can profit from management’s trades; if a mutual fund earns capital gains from a trade, it is legally obligated to pass on the profits to shareholders. Such distributions are called capital gains distributions. As a last resort, the mutual fund shares’ value can increase through standard asset appreciation.

How Do Mutual Funds Make Money?

Fund companies can charge a variety of fees for their services and products. However, where and how those fees are incorporated is important. Investors purchase mutual fund shares, triggering sales charge fees, also known as loads. Basically, the investor pays an additional percentage, usually 5%, on top of the actual price of the shares. A large portion of the sales charge usually goes to the brokers and advisors who sold the funds.

Different kinds of fund loads exist. There are various types of front-end loads, which are deducted before the shares are actually purchased. FINRA sets a cap of 8.5% on front-end charges. An investment of $1,000 with a front-end load sends $50 to the broker and $950 to purchase shares of a mutual fund.

The shares can also be sold with back-end charges. Contingent deferred sales charges (CDSCs) are the most common of these. After a period of 7 to 10 years, this load usually drops to zero.

Purchase and redemption fees are charged by some fund companies. These charges sound a lot like sales fees, but they are actually paid to the fund directly, not the broker. When shares are purchased, there are purchase fees, and when the shares are sold, there are redemption fees.

The success of a fund, as well as the continued trading of shares by the public, determines management fees. A successful fund is typically liquid and sees a lot of new money; more trading means more fee income.

Annual Fund Operating Expenses

Companies that operate as mutual funds incur expenses that must be recovered. The costs of operating the firm include paying the investment advisor, the administrative staff, fund research analysts, and distribution fees.

Instead of charging shareholders directly, management fees are paid out of the assets of the fund. Management fees are required to be listed separately and not included in the “other” expenses category, so investors can always keep track of which funds spend the most on management compensation.

In most cases, investors will hear about distribution fees, more commonly known as 12b-1 fees. The mutual fund industry has become increasingly competitive, especially since the late 1990s, and as a result, 12b-1 fees have narrowed and shareholders have become more sensitive to them. 

The fees may be capped at 1 percent of assets, but they are charged to shareholders to recoup marketing costs. Many of these costs are unavoidable; for example, the SEC requires new investors to receive prospectuses.

Fees for 12b-1 shares vary by share class. Some mutual funds reduce front-end loads based on the size of the investment, and Class A shares often charge front-end loads and have low 12b-1 costs. The industry refers to these as “breakpoints.” To entice investors, mutual fund companies are willing to sacrifice some revenue on a per-share basis. Shares of Class B and Class C tend to have higher annual expenses than those of Class A.

No-Load Funds

They are called no-load funds because they don’t charge sales charges. There are still fees associated with them, though. They may still defray marketing and distribution costs by charging 12b-1 fees, but the SEC does not permit them to claim that they are no-load if 12b-1 fees exceed 0.25%.6 Others, such as the Vanguard family of funds, do not charge sales charges or 12b-1 fees at all.

However, these companies also tend to reduce costs to compensate for the lack of sales charge income, so no-load funds can still earn revenue from other sources. Funds that have a more passive investment strategy often have less active investment management.

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