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Friday, April 9, 1999

An Investment Opinion
by Warren Gump

Check out the SEC Fee Calculator

Since its inception, The Motley Fool has been advocating the use of low-cost index funds over actively managed funds for investors who don't have the time or inclination to pick individual stocks. The primary reason for our preference of these funds is their outperformance over actively managed funds over the years. Over the past ten years, for example, the S&P 500 index has beaten almost 90% of all actively managed equity funds. A big reason for this poor performance is that actively managed funds must pay a manager and analysts to pick stocks, causing their expenses generally to be much higher than a passively managed index fund. How important are these expenses to investment performance? The Securities and Exchange Commission (SEC) has just released an online calculator that will show you.

You wouldn't think that calculating the expenses of a mutual fund would be
difficult, but in fact it is a somewhat complicated procedure. First, all of the fees charged are based on a percentage of assets under management. No quick and easy $50 for this, $25 for that. Instead, it is 0.50% of assets for this and 0.25% of assets for that. Next, on top of the actual dollars you pay in expenses, you have to incorporate the foregone earnings you would have made if your fees were invested. Let's say you paid an initial fee (or "load" in industry terms) of $100 on an investment that returned 11%. Your ending balance a year later will actually be $111 lower than an investment without a load because you lose out on the $11 gain your load would have earned had it been invested. As you will soon see, foregone earnings can be a major issue, particularly for long-term investors. The SEC calculator incorporates all of these costs.

Let's look at the difference between a high cost and a low cost fund to see how much fund fees can ultimately cost you. For comparison, we'll use three different S&P 500 index funds that are currently available. We'll assume that an investor puts $10,000 in each fund and the expected gross return is 11% per year. All of the loads and expenses used in the example below were pulled from online prospectuses:

1) Morgan Stanley Dean Witter S&P 500 Index Fund Class A
Load: 5.25% Front-end     Ongoing fees (incl. 12b-1): 0.74%

2) Morgan Stanley Dean Witter S&P 500 Index Fund Class C
Load: None     Ongoing fees (incl. 12b-1): 1.50%

3) Vanguard Index Trust -- 500 Portfolio
Load: None     Ongoing fees (incl. 12b-1): 0.19%

Here are the values and expenses for the portfolios after 10 years:

Paid Foregone
Fund Ending Value Expenses Earnings
MSDW 500--A $24,977.66 $1,776.05 $3,416.55
MSDW 500--C $24,411.37 $2,570.44 $3,982.84
Vanguard 500 $27,859.31 $ 349.11 $534.90

After 30 years, the calculations are as follows:

Paid Foregone
Fund Ending Value Expenses Earnings
MSDW 500--A $173,578.81 $13,767.99 $55,344.16
MSDW 500--C $145,470.95 $24,162.74 $83,452.01
Vanguard 500 $216,227.55 $4,031.24 $12,695.41

As you can clearly see, the impact of fees is dramatic. Over a 10-year period, the low-cost Vanguard fund will save you around $3,000 or more over the Morgan Stanley Funds. The discrepancy becomes even more significant over longer periods of time. Over 30 years, the Vanguard fund will save you more than $40,000 over the Morgan Stanley Class A shares and more than $70,000 over the Morgan Stanley Class C shares. As mentioned previously, these are good comparisons since each fund is designed to mimic the same index.

This example shows you how Morgan Stanley is lining its pockets at your expense. If you think that the advice provided by the company's brokers is worth these high fees, go for it. But if you would prefer $40,000 or more in your coffers after 30 years, avoid that Morgan Stanley fund like the plague. This example brings up a very important point. The Motley Fool doesn't advocate simply investing in any index fund... you should put your money into a low-cost index fund.

You might be surprised to see that the cost of foregone earnings is much greater than the actual costs paid to the funds for long-term holders. When paying fees and loads, you are not only losing out on the money you are paying to the fund for operations. You are also missing out on the gains that those fees could have earned if they were invested in the fund. This severely hampers the terminal value of your investment, particularly if fees and loads are high. Over the 30-year period in the example above, the Vanguard 500 fund saves an investor $9,700 in paid fees relative to the Morgan Stanley 500 Class A shares. More importantly, though, this investor saves over $30,000... that's $30,000 in foregone earnings that you would have been lost if the money were in the Morgan Stanley option.

Evaluating comparable index funds simply on cost is reasonable since their expected return should always be the same. The ultimate decision on which fund to buy is simple -- go with the fund that has the lowest overall total expenses over your investment horizon. If for some reason you decide to venture into actively managed portfolios, however, the decision becomes more complicated. You need to evaluate whether the investment manager can overcome the fees you will be charged.

Most active managers trail the market indices because of the expenses investors must pay for active management. Using the SEC calculator will clearly show you the dollar value of the disadvantage caused by a fund's fee structure. Before investing in a fund with a high expense structure, you need to be confident that its managers can beat your investment alternatives by at least the amount of the load and expenses. The calculator will help you see how much a manager will need to outperform the market to overcome the handicap of higher expenses. (One aside: the calculator does not incorporate the expense of higher capital gains taxes likely to be incurred in an actively managed fund.)

Taking advantage of the SEC's new calculator will make you a much more informed investor. Before going to the site, find out the load and expense ratio (available in the prospectus) of each fund you're considering so that you can enter them into the calculator. Once you determine how much funds really cost, you'll see why The Motley Fool encourages you to place your mutual fund investments into low-cost index funds.

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