Mutual Funds Fees & Expenses Only One Factor
Q: I often read about avoiding high expenses in mutual funds, but when I talked to my broker he said expenses don't matter because rates of return have to be stated after all expenses and fees. So, if I have a return of 7 percent a year and a lower-cost fund also has a return of 7 percent, it's all the same to me. Is this correct?
A: Your broker is correct in that, when a fund advertises a return of 7 percent it means the fund returned 7 percent after subtracting the fund's operating expenses, also called the "expense ratio." Among other things, these expenses include the fees paid to the portfolio managers who run the fund, the cost of servicing shareholder accounts, including the printing and mailing of account statements and fund prospectuses and reports, and any ongoing "distribution" fees, including commissions, for the marketing and selling of fund shares. However, the advertised return may not always include a one-time sales commission or "load" that some funds charge at the time you buy.
So, aside from any sales charge, a 7 percent return means 7 percent whether the fund is high-cost or low-cost.
A high-cost fund, however, starts with a handicap in the performance race.
A fund that charges 1.5 percent in annual expenses must return 8.5 percent a year before expenses for you to keep 7 percent. A moderate-cost fund charging 0.75 percent in annual expenses needs to return only 7.75 percent. A low-cost index fund charging just 0.10 percent in expenses need return only 7.10 before expenses.
Therefore, costs do matter and the burden of proof is on whomever is trying to sell you a higher-cost fund to justify the presumption such fund will match or exceed the performance of a lower-cost fund. I find such presumptions highly questionable and motivated often by a desire to earn a seller's commission. Future fund performance is unpredictable, but expenses represent a known hurdle the fund must overcome.
Still, expenses are not the only factor to consider when choosing a fund. See next question:
Q: I've been told there are other costs besides the expense ratio that a fund does not have to publish. The Web site http://www.personalfund.com lists the fund cost from the prospectus and also the total estimated cost to own the fund. Is this an accurate representation?
A: The PersonalFund.com Web site goes beyond a fund's published expenses. It includes an estimate of the investor's proportionate share of the transaction costs the fund manager incurs when buying and selling securities for the fund - costs not included in the expense ratio - and the estimated cost of taxes investors pay on dividends and capital gains distributions.
The site offers useful information and has earned deserved plaudits from consumer advocates. But I question the wisdom of acting on expenses alone if, to quote the site's words, you are "wondering whether to dump" a fund you own for a less expensive one.
Out of curiosity, I entered a consistently top-performing, moderate-cost fund I own that follows a disciplined "value" investment strategy I like and understand. The site suggested I would save thousands of dollars over the years by switching to a lower-cost fund. But the suggested fund follows a more aggressive approach I do not favor and has not come close to matching the performance of the fund I own, nor do I expect it to do so in the future.
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Investing - Mutual Funds Fees & Expenses Only One Factor
(c) 2010 Humberto Cruz