No Transaction Fund Fees: Are They Really Free?

Mutual fund expense ratios are far too high. There’s no justification for charging investors 1% of assets per year and more. On a $1-billion fund, that comes to annual fees of $10 million. That’s outrageous.

But fund firms aren’t the only ones taking advantage of individual investors. Online brokerages play a huge, but hidden, role. How? By charging fund companies 0.40% of assets a year to participate in their no-transaction-fee (NTF) programs. And asset managers offset most of those extra costs by charging higher total expenses for funds that participate in NTF programs.

But here’s the kick in the pants for fund shareholders: Funds participating in the NTF programs must charge the same annual expense ratio to all of their investors -- whether they invest through Schwab, Fidelity and TD Ameritrade or buy directly from the fund. “You have to use the same expense ratio across the board,” says a fund manager who prefers not to be identified. Of course, the fund firms, not the brokers, pocket the entire expense ratio on money invested directly in their funds.

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Here’s how the NTF programs work. Say the Gonzo Fund wants to be sold through Schwab’s NTF network -- that is, be available to individual investors without those pesky transaction fees of $50, which are charged both to buy and sell the fund. The firm that sponsors Gonzo Fund must pay Schwab 0.40% annually of all Gonzo Fund assets owned through Schwab’s NTF network. Fidelity charges the same 0.40%, as does TD Ameritrade. “Brokerages demand these payments before they’ll put funds on their platforms,” says Niels Holch, of the Coalition of Mutual Fund Investors, a nonprofit advocacy group.

Online brokerages do perform services for that 0.40%. They take client phone calls, mail out statements and provide other client services. But these hardly seem worth 0.40% a year. “I think they should be paid,” says my fund-manager source. “But 0.40% is way too high. The value added isn’t that much. This is an enormously profitable business for the brokers.”

Schwab and Fidelity defend the charges as reasonable. “The activities provided for the service fee we provide are obviously compelling,” a Schwab spokesman says via e-mail. “We believe that the fee is in line with our cost of service and guidance delivery to shareholders,” echoes a Fidelity spokesman. TD Ameritrade declined to comment.

Plenty of fund managers and fund executives grumble quietly about the fees, which are known in the trade as “revenue sharing.” But they’re afraid of doing anything about their predicament -- a testimony to the immense power the online brokerages wield in the mutual fund world. Even the few fund firms that have bucked the NTF programs declined to discuss the networks -- on or off the record. For instance, Vanguard, which refuses to participate in any NTF programs, presumably to maintain its status as the industry’s low-fee leader, declines to comment. The total expense ratio of most Vanguard funds is less than 0.40% annually.

Why the nervousness? Because the big three online brokers represent a huge percentage of most funds’ businesses. They’re especially important for small fund firms that are trying to gain assets in a crowded marketplace.

Investors should shun “free” funds. What’s an individual investor to do? The answer is simple. If there’s a choice between an NTF fund and a similar fund with a transaction fee, don’t immediately pick the NTF fund. Instead, look up the expense ratios of the two funds (you can do this with the Kiplinger's Mutual Fund Finder).

Then do the arithmetic. Ninety times out of 100, the cheaper fund will be the better deal than the “free,” or NTF, fund -- assuming you hold the fund with the lower expense ratio for a few years. Generally, NTF funds cost at least 0.25 percentage point more than non-NTF funds. If you’re investing $15,000 in a fund and plan to hold it four years, an expense ratio that’s 0.25 point higher will set you back $150. Compare that with the transaction fees on non-NTF funds.

Unfortunately, many online investors fall for a psychological trick. The transaction fees -- typically $24 to $50 each way -- are visible. Fund expense ratios are out of sight and out of mind. Plus, it can be emotionally difficult to pay a transaction fee for a fund that you could buy without a fee directly from the fund company. (See Think Like A Squirrel for more about this kind of financial behavior.)

Recognize that the online brokerages offer convenience -- and that that’s worth something. And if paying the transaction fee keeps you from selling the fund for years to come, that’s usually a wise move. Research has shown that investors who trade frequently generally lag those who trade infrequently. (For more on investor activity’s negative effects on returns, see Investors Lose Big with Market Timing.)

NTF programs are a bad deal in another way. NTF funds typically receive a tidal wave of money when performance is red-hot. The money flows out just as rapidly when returns cool. That swift ebb and flow of dollars hurts a fund’s long-term returns because it forces managers to buy and sell securities at times when they may be better off doing the opposite. In-flows and out-flows are usually much less volatile for funds that are outside NTF networks.

Steven T. Goldberg (bio) is an investment adviser.