How do asset managers make money? Fund fees and commissions explained

Initial sales charges, management fees, performance fees and ongoing costs: Investing in a fund can involve several different types of fees. Depending on the type of charge, the money goes to different parties, such as the asset manager, banks or financial advisers.

Asset managers earn most of their revenue from management fees and, depending on the fund, performance fees. Initial sales charges and ongoing distribution commissions may be used to pay banks or financial advisers. Ongoing distribution commissions may already be included in the management fee rather than charged on top. Other costs arise from fund administration, depositary services and auditing, for example.

The key is therefore not just to understand who receives each fee, but also what it pays for and what specific benefit investors receive in return. The management fee, for example, pays for implementing the investment strategy and managing the fund on an ongoing basis. For investors, this means entrusting these tasks to specialists rather than having to select and monitor each individual investment themselves. Audit fees pay for an independent audit of the fund by an audit firm. For investors, this provides an additional independent check and helps enhance the reliability of the fund's financial reporting. Other costs cover fund administration and independent oversight. This helps ensure that key fund operations are handled professionally and subject to independent controls.

From the initial purchase to the ongoing investment, five questions help explain where the money goes:

• What is an initial sales charge on a fund, and who receives it?
• How do asset managers earn management and performance fees?
• How do banks and financial advisers make money from funds?
• What other fund costs are there, and how do they affect performance?
• Why does the same fund have share classes with different fees?

When an investor buys fund shares, where the money goes depends on the share class and how it is purchased. Traditional retail share classes may carry an initial sales charge. This typically pays for distribution, for example through a bank or an intermediary. The asset manager does not usually receive it.

The prospectus sets out the maximum initial sales charge. The distributor does not have to charge this amount in full. It may apply a lower charge or waive it altogether.

Example: How an initial sales charge affects the amount invested

For an investment of EUR 100,000 with a 2% initial sales charge, EUR 98,000 is invested. The remaining EUR 2,000 typically goes to the distributor, such as a bank or intermediary. Where several distributors are involved, the amount may be split between them.

The bank holding the investor's securities account may also charge trading or settlement fees. Buying fund shares on an exchange can also involve a bid-ask spread, increasing the cost of the purchase.

This applies to ETFs as well as traditional funds where they are traded on an exchange. The absence of an initial sales charge therefore does not necessarily mean there are no other purchase costs.

Asset managers are primarily paid through management fees and performance fees. Depending on the fund, one or both may apply.

• Management fee: A key source of revenue for asset managers is the ongoing fee for managing the fund, known as the management fee. It is usually calculated as a percentage of assets under management. If assets under management increase while the fee rate stays the same, management fee revenue also rises. This ongoing fee may also be charged when the fund's performance is negative. It pays for the service of managing the fund, not solely for delivering positive returns. For actively managed funds, this includes the analysis and selection of investments, ongoing portfolio monitoring and risk management within the defined investment strategy. Investors therefore benefit from the expertise and technical resources of the fund management team without having to carry out this work themselves.
• Performance fee: Some funds also charge a performance-based fee, known as a performance fee. This can also be part of a fee structure with no fixed management fee. The prospectus sets out whether a performance fee applies, the threshold the fund must meet and the asset manager's share of any performance above that threshold. Performance may be measured against a fixed target or a benchmark index, for example. Performance fee structures are regulated by ESMA, a European regulatory authority, and payments are subject to review by the fund's auditor. Asset managers therefore cannot determine the calculation method without restriction.

Revenue from management fees is not the same as the asset manager's profit. Among other things, it pays for fund managers' salaries, other employees, distribution, premises and technology infrastructure.

A simplified example illustrates how this works:

A fund returns 10% before the performance fee is deducted. The agreed threshold is 5%, so the fund exceeds it by five percentage points. The asset manager receives 10% of this excess return, equivalent to 0.5 percentage points. After deducting the performance fee, the return in this example is 9.5%.

Performance fees may be recognised gradually over the course of the year through a process known as accrual. If the relevant performance subsequently falls, the amount accrued for the performance fee is reduced accordingly. The previously accrued amount is credited back to the fund and, in turn, its investors. The details of this process and the timing of the final calculation and payment depend on the specific performance fee arrangement.

Shortfalls from previous years may also matter. Where a high-water mark applies, these shortfalls must first be recovered before another performance fee can arise. The particular fee model determines which shortfalls must be taken into account.

With a relative performance model, a performance fee may arise even when the fund's return is negative. If a benchmark index falls by 30%, for example, while the fund falls by 20%, the fund has outperformed the index by ten percentage points.

At an illustrative fee rate of 10% of this outperformance, the performance fee amounts to one percentage point. This model rewards performance relative to the benchmark, rather than an absolute gain. Investors should therefore check how the performance fee is structured, either themselves or through their adviser.

An initial sales charge is not the only way distributors may be paid. Ongoing distribution commission, also known as trail commission or a retrocession, is paid by the asset manager to a distributor such as a bank, platform or intermediary. It may be funded from part of the management fee.

• Commission-based model: A fund might, for example, charge an annual management fee of 1% of assets under management. Of that, 0.4 percentage points may be passed on to the distributor as ongoing distribution commission. The investor does not pay 1.4% as a result. The 0.4 percentage points are already included in the 1% management fee.

In a platform model, funds are distributed through a platform that may work with advisers or intermediaries. The distribution commission may then be split further. For example, the platform may retain one portion and pass another on to participating intermediaries. This can pay for services such as advice, ongoing client support, fund information or communication with the asset manager.

• Fee-based model: The client pays the adviser directly for advice. The fee may be based on time spent or on the value of the assets covered by the service. The terms are determined by the agreement between the client and the adviser or wealth manager.

Clean share classes can be used for these arrangements. They do not include the relevant ongoing distribution commission, and an initial sales charge may also be waived. Instead, the client pays separately for advice.

Essentially, these are two different ways of paying for advice: Through distribution commissions or through direct payment by the client to the adviser or wealth manager.

An investment fund may incur operating costs in addition to management fees, performance fees and distribution charges. These costs do not necessarily represent revenue for the asset manager. Some also pay for independent audits and other oversight mechanisms.

Other fund costs may include:

• Fund administration: Separate fees may apply to fund administration. They pay for the administrative work involved in the day-to-day operation of the fund.
• The fund's depositary or custodian bank: This is separate from the asset manager and performs an oversight role. In particular, this separation is intended to prevent conflicts of interest when calculating the fund's share price. The fund's custodian bank should not be confused with the bank holding an individual investor's securities account. Custody means that the fund's securities, such as individual shares or bonds, are held in safekeeping on its behalf.
• Auditing: The fund pays for an auditor to carry out an independent audit of the fund and its annual report. This provides investors with an additional check on the fund's financial reporting.
• Regulatory costs: Costs may also arise from the regulation and supervision of a fund. The associated oversight mechanisms are intended to help ensure compliance with the rules that apply to it.
• Taxe d'abonnement: Luxembourg funds may also be subject to the taxe d'abonnement, a tax levied on the fund. This is a tax, not payment for an additional service provided to investors.
• Transaction costs: Buying and selling securities within a fund incurs trading costs. These vary by asset class and by the security being traded. For an asset manager without an affiliated trading business of its own, these transaction costs do not automatically generate revenue. In other words, the asset manager does not earn this money and instead has an incentive to keep these costs as low as possible.

Costs incurred within the fund are already reflected in its share price and therefore in its reported net performance. These include, for example, the management fee, any performance fee, and costs for fund administration, depositary services, auditing and transactions. Ongoing distribution commission paid out of the management fee is not charged to the investor a second time.

These costs must therefore not be deducted again from performance figures that are already reported after costs.

Investors will also encounter different cost disclosures, such as the total expense ratio (TER), ongoing charges and the costs shown in the key information document. These may cover different cost components. Transaction costs in these disclosures are sometimes calculated using models. Forward-looking figures, known as ex ante figures, and backward-looking figures, known as ex post figures, can also differ because of the calculation methods used.

Costs borne by individual investors need to be distinguished from fund costs that are already reflected in net performance. They may include an initial sales charge, as well as trading or settlement fees charged by the bank holding the investor's securities account. Buying on an exchange can also involve a bid-ask spread.

This spread can exceed a full year's management fee when a trade is placed at an unfavourable time, such as buying a US equity fund before the US stock market opens, or when trading a more specialised ETF or fund. These costs are not included in the fund's performance figures and may reduce the investor's actual return.

Different share classes allow the same fund to cater for different investor needs. They may differ in their income distributions, tax requirements, minimum investment amounts or fee arrangements. There is no need to set up a separate fund for each variation.

This creates economies of scale. Certain essential operating costs, such as auditing, can be spread across a larger pool of fund assets. Investors use the same investment strategy, while their share classes may have different terms.

• Traditional retail share classes may have an initial sales charge and a higher management fee, part of which is used to pay ongoing distribution commission.
• Clean share classes do not include the relevant ongoing distribution commission and may therefore have a lower management fee. They are not available exclusively through fee-based advisers. Self-directed investors may also buy them if they are offered by their bank.
• Institutional share classes may be restricted to certain groups of investors or require higher minimum investments. Larger investment volumes also benefit investors with smaller holdings through economies of scale. Some funds also offer special share classes for early investors. These may have more favourable fees and can subsequently be closed to further investment.
• No-load share classes do not carry an initial sales charge. However, their ongoing fees or ongoing distribution commission may be higher. A share class without an initial sales charge is therefore not necessarily cheaper overall than one with an initial sales charge and lower ongoing costs.

A fee comparison therefore needs to look beyond a single charge. Ongoing costs and any separately agreed advisory fee also matter. Different share classes reflect different ways of paying for fund management, distribution and advice.

Asset managers earn most of their revenue from management fees and, depending on the fund, performance fees. Other costs associated with investing in a fund may pay banks, financial advisers or other parties, or support the safe operation of the fund.

Distinguishing between the different types of costs and their recipients makes it easier to understand how asset managers make money and what other costs a fund investment may involve.

For investors, it is therefore not only the level of costs that matters, but also what they receive in return: Which tasks are carried out on their behalf, and what specific benefits do they gain from them? Higher fees alone are not evidence of a better investment.

Four simple tips for investing in funds

• Focus on net returns: What matters is the return a fund has delivered after costs and the level of risk taken to achieve it. Ongoing fund costs are already reflected in net performance and should not be deducted again. If the returns and risk profile remain attractive, that goes a long way towards answering whether the costs are justified.
• Check the upfront costs: Buying fund shares may involve additional costs, particularly an initial sales charge or, when buying on an exchange, a bid-ask spread. What matters is which costs actually apply to your purchase.
• Compare share classes: The same fund may offer share classes with different fees. A share class with no initial sales charge is not necessarily cheaper overall.
• Understand the performance fee: If a fund charges a performance fee, it is worth checking the prospectus to see exactly how it works.