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People who favor index-style mutual funds and exchange-traded funds wage a holy war on fees, arguing that the more you pay in expense ratios and other fees, the more it undermines your returns. Both are correct.

Millions of investors pay higher-than-minimum fees, compensating brokers and financial advisers for their help in choosing investments. Professional help comes at a price. But what fees are reasonable?

The Securities and Exchange Commission trained its sights on what it considers to be one of the least justifiable fees, the 12b-1 fee. This fee cost investors more than $9.5 billion in 2009, according to the Investment Company Institute. And sometimes as high as 1% of the investor’s holdings a year, it pays for a variety of costs incurred by the fund company, including broker’s commission, advertising, sales and marketing.

The fee’s defenders claim it ensures small investors get the advice they need.

But critics feel it’s wrong to charge fund shareholders for expenses that add nothing to the value of their holdings. Long-term shareholders pay the 12b-1 fee year after year, regardless of whether they receive long-term investment advice. In effect, they’re subsidizing the fund company’s marketing to other, less than savvy investors.

The ordinary expense ratio, in contrast, covers expenses like salaries for analysts and stock pickers — people trying to enhance the fund’s performance. This too is paid every year, but the long-term shareholder continues to get a benefit, assuming those managers do a good job.

The SEC has proposed scrapping the old 12b-1 rule in favor of one that limits the annual marketing and service fee to 0.25% of the investor’s holdings. This move would make fee disclosure clearer. The SEC says its proposals, currently in the midst of a 90-day comment period before a final vote, would enhance competition, allowing brokers to set their own sales fees rather than rely on those dictated by the fund companies.

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Actively managed funds charge the highest fees, because they support their team of experts. Index funds and ETFs charge lower fees because they require fewer employees. They simply buy and hold the stocks or bonds in an underlying market index, like the Standard & Poor’s 500.

In addition to higher expense ratios, managed funds may charge a host of other fees in addition to the 12b-1. A front-end “load” is a one-time sales charge, similar to a broker’s commission. A 5% load would cost $50 for every $1,000 invested. Some funds charge a “back-end” load, a percentage of the proceeds from when the investor sells shares.

Many actively managed funds offer investors various “classes” of shares, each with a unique combination of fees.

  • A Shares typically carry a front-end load and, in many cases, a smaller annual expense ratio than other share classes of the same fund.
  • B Shares charge a back-end load and a bigger annual expense ratio than the fund’s A shares.
  • C Shares have the highest annual expenses and often a back-end load lower than B Shares.
  • D Shares are earmarked for sales by brokerage firms. These typically have no loads and may have low expense ratios, but the investor may have to pay some other type of commission or sales charge.

It’s important to read fund documents carefully, as there are lots of twists on these basic provisions. Back-end loads, for example, may shrink to nothing if you hold the shares long enough.

To figure which fee combination is right for you, check the Cost Analyzer provided by market-data firm Morningstar (Stock Quote: MORN).

Do-it-yourself investors do best buying no-load funds directly from the mutual fund company. Expense ratios will vary from fund to fund, but there are no share classes to wrestle with. You may see “institutional shares” with lower expense ratios than “investor” shares of the same fund. Institutional shares are typically restricted to large investors, like those with $1 million or more in the fund.

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