Keep Mutual Fund Fees Low To Improve Returns

by Todd Smith on 2011-05-082

Financial advisors have their biases when it comes to what kind of products they offer you. They also have disparate philosophies on many aspects of investing, mainly as their approaches affect their bottom line and profitability. For instance, a colleague of mine in the financial planning field confessed to me that he wasn’t well liked by other advisors in his area. I wondered why this was the case, as I felt that my friend was an ethical and pretty likeable fellow. Apparently, the reason for his notoriety stems from the fact that he has called out certain financial advisors who were part of a popular investment boutique firm for selling inappropriate products to clients and prospects. The issue wasn’t the type of products they were selling, as much as it was to do with the fees and costs that those products had, while providing no additional benefit to customers. And so goes the debate on mutual fund costs, which appears to generate enough bad blood among those of us in the financial planning field.

Chasing Investment Returns? Focus On What You Can Control

Now all of us as investors would certainly be quite pleased if we could squeeze a little bit more out of our portfolios. Who wouldn’t be happy with an extra percentage (or more) yield from our investments? Interestingly, a lot of investors I have seen over the years focus on what they cannot control too well, and instead, ignore (or don’t realize) one of the biggest things they can control: investment costs. Many investors spend their time and energy trying to figure out the best investment to have, when to buy or sell, and which direction the market is heading; but these are all futile attempts, in my opinion. For years, I have been urging people to pay attention to costs and to keep them reasonable.

Many of you may be asking why costs are so important. After all, you typically get what you pay for, right? WRONG. Let me give you a simple example.

Say you have a stock mutual fund that keeps pace with the market and earns 10% on an average year. That’s pretty good. But if you have an expense ratio of 1.5% and you paid another 5% upfront to purchase it, your after-cost return is really only 3.5%. And if you were to factor in an average historical inflation rate of around 4% per year, your 10% return quickly erodes to -0.5% after the costs are applied. And what about taxes? You’ll have to consider this factor as well. Given all this, your investment doesn’t look so great any more does it? While you can only hope to outpace inflation over the long-term, you can make sure your costs do not cause an additional “drag” to your performance and growth. While a percentage (or 1 basis point) here and there may not seem like a big deal, over 5, 10, 20 or even 30 years, it can certainly make a big difference!

Mutual Fund Fees and Expenses Affect Your Returns

1. Expense Ratios and 12B-1 Fees
Mutual funds can cost you in a couple of different ways: there are internal, inherent fund costs, as well as fees when you buy or sell the fund (which we’ll discuss later). The internal cost of the fund is commonly known as the expense ratio. This, in essence, is what it costs to operate and manage the fund. Index or passively managed funds are obviously going to have much lower costs compared to their actively managed peers. Also, within this expense, you usually have 12b-1 fees for advertising and promotions. While it may be neat to see your mutual fund company on the Super Bowl ads, you can guess who is paying for it in the way of higher expenses. So before you consider purchasing a mutual fund, look at these matters first.

2. Load Fees and Transaction Costs
In addition, when you buy a fund there may be a sales charge or commission at the point of sale unless it is a no-load fund. The loaded funds (with a sales charge) typically have an A share (upfront from 2% to 6%), a B share (a contingent deferred sales charge depending on when you sell it), or a C share (usually a yearly annual charge of 1%, for instance). The biggest gripe my colleague (the advisor in my story earlier) had with other financial planners was the fact that they were always selling A shares. And when these A shares were not available, they would push for B or C shares that had less visible commission schedules. But that wasn’t even the real kicker. You see, some funds have no load equivalents, but these advisors would not get paid if they sold these products (they were not what you call no-fee advisors, but rather, those who got paid with commissions). So, instead of acting as a fiduciary and doing the best for their client, they were selling the funds under the A or B share class. Unfortunately for their customers, many of these funds have high expense ratios.

Financial advisors may defend their position with A, B or C share loaded funds. If you’re a customer who asks your financial planner, investment advisor or even your insurance agent the right questions about these products, you may hear them vigorously defending these funds by claiming that their performance more than makes up for these costs. Of course, this is not always the case.

But I will also go so far as to say that not all commissioned-based advisors are bad. Frankly, that’s their selling proposition –- “yes, you pay more, but then you’ll have my services.” That’s well and good if they are earning you enough to cover this added expense and have plenty of value-adds to your financial life. But do you see the conflict of interest here? Many advisors under this pay model have to make a choice between getting paid or doing the right thing for the client. Too often, it goes the advisors’ way without the client knowing. That’s why, given the choice, I would always opt for a no-load fund purchased directly from the fund company and/or use a fee-only planner. That way, this potential conflict of interest is automatically removed.

Tip: You can find many mutual funds with low costs and fees at many popular brokerages. Here’s a list of mutual fund brokers you can check.

Things To Know About Fund Costs

Some interesting investment options currently available include no load index mutual funds like those offered by Vanguard, Charles Schwab, E*Trade and Fidelity, which have low expense ratios that are under .20%. Here are some pointers to remember about mutual fund fees, expenses and costs:

  • Costs add up over time. The lower they are, the more money you get to keep.
  • Costs are actually a better predictor of future performance than anything else.
  • Fees and expenses play a large part in affecting the performance of a no load index fund. That’s because costs are the main differentiator for such funds.
  • Fees and expenses are just some of the factors that you need to evaluate when you are shopping for an actively managed fund. This is because performance and costs can vary a bit across such funds.
  • Fees may be used in various ways to sustain and maintain a fund. Be aware of how these costs are used to support your fund and look upon them as an indicator of your fund’s quality and priorities.

Copyright © 2011 The Digerati Life. All Rights Reserved.

{ 2 comments… read them below or add one }

Derek May 9, 2011 at 7:50 am

I agree that it doesn’t make sense to pay a higher fees when most mutual funds are not beating the index anyway. I might add to your discussion that Exchange Traded Funds (ETFs) also offer a great alternative to costly mutual funds and are typically available at a very low expense. – Derek

krantcents May 9, 2011 at 5:02 pm

Your point is well taken, you do not receive better service or a better product just because the fees are higher. Investors should be informed and shop funds for lower fees. ETFs are a good alternative in that respect.

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