Mutual fund investors often devote the majority of their effort to scrutinizing historical returns, pondering the stratification of funds within categories, and consulting the "stars," style boxes and Sharpe ratios. While each of these measures is useful, they sometimes obscure what is perhaps the most important consideration over the long run: cost.
Identifying the various costs and fees attendant to a mutual fund can be a confusing proposition. Nevertheless, the effort is essential to maximizing long-term results, and the information is readily available once one knows where to look.
Start with the sales commissions, or "loads." These charges vary greatly according to how the funds are distributed, ranging from zero to over 6 percent up front. This is how the broker selling the fund gets paid. While this structure may be appropriate for very long-term holders, it generally takes at least five years to break even on the upfront sales charge.
Some funds impose no up-front sales charge but assess what is called a "contingent deferred sales charge" or back-end load if you bail out before a specified time frame designed to recoup the broker payout. These share classes are rarely a good deal for investors and are best avoided.
The past 20 years have seen increasing popularity of no-load funds (funds with no up-front or back end loads). These share classes are offered by discount brokerage firms or marketed directly to the public, so they do not need sales charges to remunerate brokers. However, they must still compensate the discount brokerage or fund supermarket platform and therefore often include other fees or transaction charges (although typically much less than sales loads).
All mutual funds also incur a variety of internal fees and expenses necessary to operate the fund, pay the money managers and cover certain marketing expenses. The sum total of these fees is summarized in the "expense ratio," stated as a percent of the fund value.
According to the Investment Company Institute, the average stock fund carries an annual expense ratio of 1.43 percent, meaning that the return to investors is reduced by 1.43 percent compared with the underlying stocks inside the fund. Some individual funds carry fees well in excess of 2 percent.
ICI reports that the asset-weighted ratio is 0.79 percent, if one averages fees over total assets in all equity funds. This lower total expense ratio derives from the surge in inexpensive passive index funds.
Note that the expense ratio does not include any sales loads charged.
Do these seemingly small differences in fees really matter? Suppose you invest $10,000 per year over the next 20 years in a no-load mutual fund expected to produce gross returns of 6 percent per year. Paying an extra 50 basis points per year in fees (1/2 of 1 percent) above the average would cost you $17,000 over 20 years. Throw in sales charges, and you could easily forfeit $25,000 or more.
Understand all the fees and keep them low. This could be the most important investment decision you make this year.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfreepress.com.