Let’s say that I own a particular mutual fund in an IRA or brokerage account. We’ll call this fund “Bond Fund Class A”. I have owned Bond Fund Class A for a number of years and, while I paid a sales charge on my initial investment, I now pay roughly 1% a year in operating expenses. Bond Fund Class A nets a portion of this charge from the net assets of the fund (on a daily basis), and everyone who owns the fund pays this fee.

Assuming that I don’t make any additional purchases that might incur additional sales charges, I can reasonably expect to continue to pay 1% as an operating expense on my investment in Bond Fund Class A for the foreseeable future.

Where does the money generated by this fee go? To put it another way, who am I paying? The chart below shows a typical split of how this 1% annual operating expense is allocated. Other expenses can sometimes be involved such as Short Term Redemption Fees, designed to discourage short term transactions in funds for market timing purposes. In the interest of brevity, I will limit myself to the most common components of expenses that all investors face.

Of the three components that combine to make the 1% fee, you will note that 0.35% of the fee goes to the individuals who manage the fund (the people who make the decisions as to which stocks to buy or sell on a daily basis).

An additional 0.40% of the fee goes to “Other Operating Expenses”. This somewhat vague category can involve a number of different things, but we’ll over-generalize it here by saying that this part of the fee goes to all of the administrative functions needed to keep Bond Fund Class A running.

A number of other housekeeping and operational items also fall in to this broad line item. Probably the most important to me is the fact that the firm who runs Bond Fund A, which we’ll call “Firm ABC,” has to keep up with me as an individual investor. When I have a question, it’s someone from Firm ABC that takes my call. When I move and need to have my statement sent to my new address, it’s once again Firm ABC’s responsibility (Firm ABC may be split into several affiliated companies to perform these service but, ultimately, it’s still Firm ABC).

The final component of the fee (0.25%) is for something called a “12b-1 Servicing Fee”. This particular fee – and its merits – have been debated for years. Firm ABC’s prospectus tells me that the fee is paid to the broker who originally sold me the fund and is used for ongoing marketing expenses. An easier, probably more accurate, definition of this expense is simply that it is an additional, ongoing commission for that same broker.
These components all add up to the 1% fee that is netted from the gross returns of Bond Fund Class A. If Bond Fund Class A makes a gross return of 10% this year, I and the other shareholders will receive 9% (a little over-simplified on the math, but basically correct).

With some allowances for the vague operating expenses and the 12b-1 Servicing Fees, this exercise has been a fairly straightforward look at how investing meets revenue sharing. We’re about to make it a little more complicated.

*Originally published February, 2008.