Let's say you were assessing whether or not a mutual fund was likely to outperform the market over the next ten years and were allowed to ask one and only one question about it. What would that question be? "What is the fund's three-year return?" "What is the ten-year return?" "What is the mutual fund's favorite color?" "Briefs or boxers?"
No, it really shouldn't be any of these. (Though if somebody would like to ask either of these last two questions to a broker trying to sell them a mutual fund, and wishes to write it up as a Fribble, there's a pretty good chance that we might publish it.)
Returning to the matter at issue, the first question that you should answer before buying or deciding to continue to own a mutual fund is "What about the costs?" While a recent mainstream press news article has declared that most fund investors are "[d]azzled by performance, indifferent to cost," we hope to elevate you to well above the average in the next 500 words or so.
The costs of owning a fund are called the expense ratio. (This is distinct from the costs of buying a fund, which are the sales loads which we describe here. The expense ratio represents the percentage of the fund's assets that go purely toward the expense of running the fund. The expense ratio covers the investment advisory fee, the administrative costs, 12b-1 distribution fees, and other operating expenses.
The nifty thing about the expense ratio is that it wraps all these various costs and expenses into one number so that you don't have to do a lot of math. Currently the typical expense ratio for an actively managed mutual fund is about 1.5%, and that number has been going up lately. With an expense ratio of 1.5%, a mutual fund is cutting itself in on 1.5% of the total money in the fund every year. That's whether there's a good year or a bad year for the fund. Even if the stock market doesn't go up at all over the course of the year, the mutual fund will still pay itself 1.5% of the assets within the fund. With the trend being the way that it is, you as a potential or actual mutual fund investor should be aware that as time goes by, it is likely going to become more and more expensive to own an actively managed mutual fund.
An expense ratio is the total of the following components.
The investment advisory fee or management fee is the money necessary to pay the manager(s) of the mutual fund. On average, this fee is about 0.50% to 1.0% annually of the fund's assets, and is necessary to make sure that the manager of the fund can be very well-dressed at all times and is able to go on good vacations.
Administrative costs are the costs of record keeping, mailings, maintaining a customer service line, etc. These are all necessary costs, though they vary in size from fund to fund. The thriftiest funds can keep these costs below 0.20% of fund assets, while the ones who use engraved paper, colorful graphics, and phone answers with highfalutin' accents might fail to keep administrative costs below 0.40% of fund assets.
Surely the fee that you as a mutual fund investor should be most outraged by is the 12b-1 distribution fee. This fee ranges from 0.25% of a fund's assets all the way up to 1.0% of the fund's assets. This fee is used for marketing, advertising, and distribution services. Yup, that's right. If you're in a fund with a 12b-1 fee, you're paying every year for the fund to run commercials and try to sell itself. Can this in any way really help you? Do you enjoy seeing advertisements of your fund or your fund family on television? Unless you really do, you should probably avoid funds that charge a 12b-1 fee.
You don't really need to concern yourself too much with how these components of an expense ratio are divided. You just need to know the bottom line. For actively managed funds, the average expense ratio is rising as funds shift fees away from the up-front loads that they know are driving sales away, and into the annual expense ratios where they are more easily hidden.
Meanwhile, in the wonderful world of index funds, the expense ratio is typically around 0.25% and gets as low as 0.18% for the king of all index funds -- the Vanguard 500 Index.
However, just because a fund labels itself an index fund does not mean that it has the extremely low expense ratio of the best index funds. Some mutual fund companies, knowing that their clients have heard about the superiority of index funds, have started index funds with expense ratios of more than 1%. Avoid these like the plague. If you've read this far, you can do better than that, Fool. In fact, where index funds are concerned, you should probably simply be getting the one with the lowest expense ratio -- probably around 0.18%.
Costs matter -- tremendously. If you're buying a mutual fund using a full-service broker's advice, there's a very, very good chance that you've just bought a fund with high costs. If you want to figure out the costs of owning any mutual fund, it doesn't take long -- make sure to check out the SEC's excellent mutual fund cost calculator.
You can find the expense ratios of mutual funds at websites such as Morningstar's. You can also get the information from newspapers like The New York Times. On Wednesday of each week, The Times lists expense ratios for all mutual funds. Look over the charts and compare the expense ratios of funds managed by full-service brokerages such as Merrill Lynch or Morgan Stanley with their 1.5% to 2.0% (or higher!) average expense ratios. Then look at Vanguard's table showing averages of less than 0.5%. Remarkable.
There's more to the underperformance of mutual funds than charging too much. There also is the behavior of mutual funds as overactive traders of stocks and market-timers. These habits, which will never help any portfolio over the long term, also weigh heavily on the performance of mutual funds.
Next: Turnover and Cash Reserves »