Are You Being Ripped Off by High-Cost Mutual Funds?

If you're not careful, mutual funds can bleed your portfolio dry. Buy the wrong funds or play switcheroo with your holdings too often and your nest egg can get kneecapped in a heartbeat.

Paying too much for mutual funds is an issue that any investor can fall victim to, but investors that use brokers or financial advisors need to be especially careful. In The Motley Fool's recent special report on financial advisors, we highlighted the troublesome incentives that arise from brokers and advisors that make money from commissions. Because commission-based advisors' income stems from the fees from the funds they sell you, they're not necessarily incentivized to work in your best interests.

So how do you make sure that the funds you're being recommended aren't going to give your portfolio the vampire treatment? The three steps below are a great place to start.

1. Make sure you have the right advisor.
If you don't already have an advisor and you're starting from square one, finding an advisor that is fee-only and works under a fiduciary standard are two criteria you seek out.

A fee-only advisor is one that charges you a fee for services -- either based on the amount of assets they're managing for you or a fixed fee per hour that they spend working on your account -- and doesn't collect any commissions on top of that. Though there are still conflicts of interest that can arise in a fee-only relationship, because the advisor isn't relying on commissions, you can be more assured that they're not pushing a mutual fund simply because it will pay them a high fee.

Meanwhile, an advisor that's also a fiduciary means that they agree to act in their clients' best interests at all times. Because a fiduciary can get tangled up in court for failing this standard, they take the commitment very seriously.

But while looking for a fee-only fiduciary advisor may be ideal, it doesn't mean that every advisor that takes commissions is out to swindle you. In fact, there are a great many commission-taking advisors that are great assets to their clients. However, if your advisor or broker does receive commissions, it's even more essential to make sure that you have a transparent, trusting relationship with your advisor -- that, or you keep a very close eye on the funds that they're recommending.

2. Are your funds really beating the market?
Here's the bottom line: Most mutual fund managers don't beat the market.

In 2011, the situation was particularly bleak as Morningstar reported that 79% of large-cap mutual funds lost out to the S&P 500 (INDEX: ^GSPC  ) index. That's pathetic.

Part of the reason is really simple -- actively managed funds often charge really high fees. For instance, the Columbia Acorn Emerging Markets A (CAGAX) fund charges a maximum front-end sales charge of 5.75% and then hits investors for 1.85% annually. The Oppenheimer Quest Opportunity Value A (QVOPX) hits investors with a similar maximum 5.75% front-end fee, while taking out another 1.52% annually.

Fees like that can easily make mincemeat of your portfolio, so if the returns that you're getting from your funds aren't beating appropriate benchmarks, then there's no reason that you should stand for expenses that high.

What's your other option? Go with the good ol' maxim: "If you can't beat 'em, join 'em." Aim to match the benchmarks through low-cost index funds or ETFs. The Vanguard S&P 500 ETF (NYSE: VOO  ) will track the S&P 500 for you at the rock-bottom cost of 0.05% annually. The Vanguard Dividend Appreciation ETF (NYSE: VIG  ) and the Vanguard MSCI Emerging Markets ETF (NYSE: VWO  ) , meanwhile, track the Dividend Achievers Select Index and the MSCI Emerging Markets Index with respective annual fees of 0.13% and 0.2%.

3. Trading is harmful to your wealth.
Studies from the world of behavioral finance have shown that investors are often driven by overconfidence to trade excessively. And investors that trade excessively tend to underperform their more patient, plodding counterparts.

This applies to working with a financial advisor and mutual funds just as much -- if not more -- than sitting at home and day trading stocks on your own. When mutual funds -- particularly actively managed mutual funds -- are purchased or sold, they often trigger fees. If your advisor has a penchant for jumping in and out of funds, stacking fees on top of fees, you may end up feeling like your portfolio has sprung a leak.

So, as above, if your broker or advisor has a yen for trading and can prove that his outstanding level of ability is leading to benchmark-topping performance, then let him have at it (but continue to keep an eye on the results!). However, if that trading activity is full of sound and fury, but signifying nothing -- except racking up fees -- then tell your advisor in no uncertain terms that you'd rather settle your portfolio into some nice, long-term positions in low-cost index funds.

Buyer beware
There's good reason for investors to use financial advisors. As behavioral finance expert Terrance Odean said to me, "Is there room for improvement for the behavior of individual investors on their own? Yes! Could someone that's well trained help them? Sure!" However, in order for clients to get the best experience possible from an advisor relationship, it's critical that they understand the basics of the business and how to find the right kind of advisor.

To supercharge your understanding of financial advisors, be sure to check out The Motley Fool's special report: "How to Thwart the Opaque, High-Fee, Underperforming Financial Advisors Who May Be Mismanaging Your Money."

Motley Fool newsletter services have recommended buying shares of Morningstar. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer owns shares of Vanguard Dividend Appreciation ETF and Vanguard MSCI Emerging Markets ETF, but does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (3) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 01, 2012, at 7:11 PM, XMFDivine wrote:

    Great article, wonderful points all. This topic deserves more attention. If average investors saw what these fees did to the value of their portfolios over long periods of time...whoooo, buddy, they would either faint or go out and buy a gun. Or both.

  • Report this Comment On June 01, 2012, at 8:14 PM, steamoil wrote:

    If you think your mutuals are making you money, think again.There are no funds giving you a return. All the stocks that make up the fund portfolio are taking a beating. Maybe that one or two stocks are in the plus, it means nothing while all the lemons are taking the whole fund down. A year and a half ago, I had some of the best mutuals you could find,no load, low fee's, diversity, good sectors,,everything you could you could want, I .sold them all off .When the market started to go south,the daily plusses turned negative. When I saw that my principal was at risk, They went . If you hold them for at least 90 days ,and they're are not being friendly to you any more.Sell them offIf I f I would have held on to them till now I they would have been gone. If you financial advisor tells you otherwise, he's full of it .Do youself a favor and do a little homework by looking up the mutual fund/s, check out the portfolio make-up and see just how the individual stocks are doing . I'm sure you won't like what you see, especially after a day like today.

  • Report this Comment On June 03, 2012, at 8:30 PM, Shawnerz wrote:

    Matt,

    Several months ago, there was a MF article about employeers who offer poor choices for 401K selections.

    I believe that the the employeer of the woman I'm dating offers another company's selection of funds that (I believe) are getting killed by fees.

    She's not a financial person, really doesn't understand the market, and is a "set it and forget it" type person.

    Any ideas or options? Maybe a separate article?Thanks.

    -Shawn

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