Did you ever take a close look at your phone or cable bill? You see a litany of charges that come atop your monthly fee—surcharges, taxes, this fee, that fee, and on and on.
If you own an actively managed mutual fund, one where managers buy and sell securities in attempts to outperform the markets, you’re paying a similar plethora of charges. But unlike your cable or phone company, your fund company doesn’t clearly list all charges for you. And some charges require take a determined effort to discover.
Over certain periods, some mutual funds can deliver good gross returns that can help investors build wealth. Yet in most cases, these returns are reduced by various expenses that significantly reduce net returns, so it’s important to be aware of them before investing. These charges vary from fund to fund but, in most cases, they’re daunting.
This conga line of fees may begin with sales commissions, a one-time charge known as a load. The estimated average of these commissions is a whopping 4 to 5.75 percent. Some funds promote themselves as being no load—meaning that no commission is paid.
Once you’re in an actively managed mutual fund, separately or in annuity, there are four basic types of ongoing costs:
Expense ratios. This fee goes for marketing and the high compensation of fund investment managers. The average annual expense ratio for domestic stock funds is estimated at .90 percent, according to research firm Morningstar. Many investors believe that this cost, explicitly disclosed in a fund’s prospectus, is the only ongoing expense they pay; they are mistaken.
Tax costs. This is the extra expense of taxes that investors whose funds are held in taxable accounts must pay. If you’re late to the party, buying in just before existing shareholders receive gains, you may end up paying taxes on gains you didn’t get. Also, the buying and selling of securities throughout the year by the active managers can have significant tax consequences. The estimated average tax cost for U.S. stock funds is about 1 percent per year. Though a fund’s tax cost is available to inquiring investors, it’s not explicitly disclosed like expense ratios or sales commissions. Thus, its known as in implicit cost—one that’s not clearly communicated.
Transaction costs, also an implicit cost. This aggregate figure covers costs of trading, including brokerage fees. For the average U.S. stock fund, this cost is estimated at 1.44 percent annually, according to a study by researchers at the University of Virginia, the University of California at Davis and Virginia Polytechnic Institute.
Cash drag, another implicit cost. This term refers to the degree to which keeping some of the fund’s money in cash sacrifices potential earnings. Sure, fund managers need cash to pay redemptions to investors exiting the fund. Yet you have to pay the fund’s expense ratio on 100 percent of the money you’ve invested, regardless of whether all of this money goes to buy securities. The cash drag for domestic stock funds is estimated at .83 percent per year.
Not including sales commissions, the total of these costs is a whopping 3.17 percent annually for non-taxable accounts (such as those held in IRAs or 401(k) plans) and 4.17 percent for taxable accounts. As these costs cut into net returns, is it any wonder that most mutual funds underperform simple indexes? To help avoid these high expenses, a much better way is to invest is no-load, low-cost index funds, which aim to provide the returns of the index they track—for example the S&P 500—or institutional asset class funds. Such funds are called passively managed because, unlike actively managed mutual funds, they don’t excessively buy and sell investments in futile attempts to outperform the markets.
“To help avoid these high expenses, a much better way is to invest is no-load, low-cost index funds.”
The lower turnover of index funds keeps their expenses far below than those of actively managed funds; they also save significantly on taxes. As these savings increase net returns, is it any wonder that Warren Buffett says the money he leaves his wife will be invested in low-cost index funds?
The alternative is to pay the high costs associated with actively managed funds, which lead to lower net returns.
Tim Decker is president of ISI Financial Group (www.isifinancialgroup.com), a wealth management firm in Lancaster, and a fee-only financial planner (he sells no products). His weekly call-in radio show, Financial Freedom, airs Saturdays at 10 a.m. on WHP580 AM.