Chapter 18. You Should Be Concerned About the Costs of Owning Mutual Funds

Chapter 18. You Should Be Concerned About the Costs of Owning Mutual Funds

"Mutual Funds Load up on Fees." This headline appeared on an article in The Wall Street Journal , in April 2002. ^[1]

^[1] See Jeff D. Opdyke, "Mutual Funds Load up on Fees," The Wall Street Journal , April 10, 2002, p. D2.

Many investment professionals agree that investors, in general, pay too little attention to the costs of owning a mutual fund and concentrate instead only on the reported performance numbers . This is often a costly mistake. Let us be clear at the outset: You should be very concerned about the costs of owning your mutual fund!

Investors know that mutual funds cost money to operate ”after all, investment companies are not running a charity. What investors sometimes overlook is the full extent of the costs, some of which may be hidden. Many think that the costs are about the same across all funds in a category, but this is not true.

Insights

When it comes to fund costs, what you don't know can hurt you substantially in terms of the final net performance you realize as a shareholder. Unfortunately, many mutual fund companies operate under the assumption that shareholders are not concerned with costs. They do not point out with any emphasis the details about costs. Instead, they want the shareholders and prospective purchasers to concentrate on performance.

Consider an example of the differences in costs for two mutual funds. In a recent 12-month period, the Rightime Fund charged shareholders $2.52 per $100 of fund assets. During that same 12-month period, the fund lost 21 percent. Meanwhile, for the same period, the Vanguard Windsor Fund charged its shareholders only $0.31 per $100 of fund assets and showed a performance gain of almost 24 percent. Even forgetting the difference in performance, the big difference in costs for these two funds would make a significant difference in shareholder wealth over time.

Consider the costs of owning a mutual fund. First, load funds by definition are charging a sales fee (known as a load fee) to purchasers; conversely, no-load funds are not charging a sales fee. Although the sales charge has dropped over the long haul (it used to be as high as 8.5 percent of assets), it is still in existence for many funds. It many cases it is between five and six percent. According to a recent analysis, the average load fee is 5.2 percent, which represents an increase over the recent past. ^[2] Furthermore, some funds charge transaction fees, including fees for low account balances and low activity in the account.

^[2] This statistic is based on Jeff D. Opdyke, "Mutual Funds Load up on Fees," The Wall Street Journal , April 10, 2002, p. D2.

Given the wide availability of no-load mutual funds, one might legitimately wonder why most investors typically do not buy no-load funds, thereby saving themselves substantial money up front. After all, if the sales charge (load fee) for Fund X is 5.75 percent of funds invested and you invest $10,000 in Fund X, you give up $575 right off the bat ”money you won't see again because it has gone to compensate the sales force. On the other hand, if you buy a no-load fund, all $10,000 of your money goes to work immediately in the fund.

Do you want to guess what percentage of fund purchases go to no-load funds versus load funds? You might think it would be on the order of 75 “25 in favor of no-load funds, or at worst 50 “50. You would be wrong, as Figure 18-1 shows, although this is quite surprising and somewhat difficult to understand. For recent mutual fund purchases, roughly 20 to 25 percent were no-load purchases, and roughly 75 to 80 percent were load fund purchases.

Figure 18-1. Approximate Percentage of Recent Mutual Fund Purchases That Have No Sales Charge Versus Percentage of Purchases That Have a Sales Charge.

In a recent two-year period, more than 2,500 new mutual funds were started, and roughly two thirds of them charge a load fee. ^[3] Clearly, the trend in load fees these days does not favor the investor.

^[3] This statistic is based on ICI estimates, augmented by Federal Reserve estimates.

The second cost borne by virtually all shareholders ”except in cases where it is temporarily waived as a marketing tool to attract new investors ”is the expense ratio, which shareholders pay annually. The average expense ratio for domestic equity funds is about 1.4 percent of assets due annually but payable on a more frequent basis. The most prominent part of the expense ratio is the management fee, the fee that is paid to the managers of the portfolio.

Finally, shareholders bear trading costs. The most obvious trading cost is the brokerage fee paid by the fund when it transacts. However, you can reasonably expect the fund to get a good deal on its brokerage costs, given the size and frequency of its transactions. Investors also need to realize that an impact cost might occur, resulting from the fund's impact on a stock's price as its trade takes place. Another type of trading cost is the delay cost , which occurs when a stock's price moves unfavorably as a large order is executed over time.

There are no precise figures available for these trading costs, but there are good estimates. One estimate by an investment consulting company is that the average per-trade total of these costs varies from 1.4 percent (in the case of index funds) to 1.6 percent (in the case of large-cap growth funds). For small-cap growth funds, the estimated cost is 3.1 percent. These figures double if the fund buys and sells the equivalent of its entire portfolio in a year, not an unusual occurrence. ^[4]

^[4] See Jonathan Burton, "Simply the Best," Bloomberg Personal Finance , July/August 2001, p. 54.

Keep in mind that trading costs can be largely hidden. Such costs are difficult to measure, and they basically go unreported except for commissions, a figure that is available in information from the company, but not necessarily very accessible.

How much do costs really matter? Do investors need to worry very much about a management fee of 1 percent, versus 1.5 percent, on an equity portfolio? The answer is a resounding yes! As Don Phillips of Morningstar is quoted as saying, "Low cost is an all-weather advantage. It helps you when markets are good or bad. And in an era of lower returns, it's even more important." ^[5]

^[5] This quote came from an article by John Montgomery, "Hidden Costs Cannibalize Profits," Mutual Funds , October 2000, p. 122.

Consider the following example. You own an actively managed equity mutual fund that will return 11 percent a year, before expenses, for the next 20 years . The expense ratio is 1.5 percent. Alternatively, you could own an unmanaged index fund that will also return 11 percent, before expenses, for the next 20 years, and this index fund has a very low expense ratio of 0.2 percent. You can invest $10,000 at the outset in either alternative. How much ending wealth would you have at the end of the 20 years? For the index fund, you would have $77,767, and for the equity mutual fund, you would have $61,416.

As Figure 18-2 shows, there is a large difference in the ending wealth for these two alternatives solely because of the difference in the annual expense ratio. Over time, this difference in expenses makes a large difference in the ending wealth for each alternative. The difference is $16,351 that accrues to the shareholder solely because of the difference in costs over time. Clearly, costs make a big difference in the ending wealth that can be accumulated . For bond portfolios, where average returns are much lower, cost differentials become even more important to the shareholder.

Figure 18-2. Ending Wealth for Two Funds With Different Expense Ratios Over a 20-Year Period, Each Earning 11 Percent a Year Before Expenses, and Starting With $10,000 Invested in Each.