Mutual Funds for Beginners, Part 2

As the Fool's resident fund geek -- and, not coincidentally, as the lead analyst of our Champion Funds newsletter service -- my main job is to scour the universe of mutual funds and zero in on those select few that have what it takes to beat the market over the next three to five years and beyond. And so far, so good: During the 18 months we've been up and running, our funds have beaten the market by more than 6.5 percentage points.

So, what's behind that track record so far?

Well, to home in on what we call Funds of the Month, I make use of many analytical tools and baseline concepts. Among the latter is that costs always matter, and that, especially when it comes to mutual funds, they matter a lot.

Simply put, unlike toaster ovens, dinners out, or luxury sedans, with mutual funds, you usually get what you don't pay for. Consider such index fund stalwarts Vanguard Total Stock Market (FUND: VTSMX  ) , Vanguard 500 Index (FUND: VFINX  ) , and the popular SPDRS (AMEX: SPY  ) exchange-traded fund. These fine funds will ding you just 0.19%, 0.18%, and 0.11%, respectively, to invest in them.

Even with actively managed funds, it's often the case that the best are among the cheapest, in part because of the strength of their reputations. To wit: As their assets grow, fund companies enjoy economies of scale and can lower their price tags, while still earning a tidy profit, because there are more shares to spread those fees across.

And sometimes even funds with relatively small asset bases have reasonable price tags because the folks behind them are committed to shareholders and trust that a high-quality, reasonably priced product will attract plenty of assets over time.

Consider, for example, the case of American Century Mid Cap Value, a fund whose portfolio recently included the likes of Unocal (NYSE: UCL  ) , Marsh & McLennan Companies (NYSE: MMC  ) , Union Pacific (NYSE: UNP  ) , and Freddie Mac (NYSE: FRE  ) . This offering came to market with a talented management team in 2004, has returned more than 29% over the past 12 months, and currently sports an asset base of less than $100 million. Despite that small size, however, the fund's price tag is a mere 1%.

The price you'll pay
With that as a backdrop, let's focus in this installment of the Beginner's Guide on fund fees -- and on why they're so critically important when it comes to making fund investment decisions.

First up: the expense ratio. Simply put, a fund's expense ratio represents the percentage of your assets that the firm behind the fund will take each year in exchange for its services. These services include the work your portfolio manager does, as well as administrative costs.

In some cases, an expense ratio is also padded by an odious fee known as a 12b-1, a surcharge the fund company charges shareholders for the sake of marketing and distributing the fund. There are occasional exceptions to the rule, but at Champion Funds, I generally turn up my nose at funds that pass along these costs to their investors.

All things being equal, the lower a fund's expense ratio the better, since that means that a manager has an easier bar to clear each year relative to pricier peers and his expense-free benchmark. Beyond that, as I noted above, with mutual funds, it simply isn't the case that the more you pay, the more you get. Indeed, some of my favorite funds will ding you 1% or less -- and these are funds whose managers have solid track records of beating the market over the long haul.

Other costs
In addition to the expense ratio, all funds incur transaction costs when their managers make trades, and these fees come right out of your assets, too.

Though I'm always on the lookout for managers who strive to keep their trading costs down, you can't object on principle to transaction costs. That, after all, is the price of playing the stock market game. Not so loads, however, which are sales charges taken out of the amount you invest in a fund given to the broker or advisor who steered you in the direction of the fund, presumably with some savvy financial advice.

Here's some advice, which I'll offer gratis: Avoid load funds!

I've yet to encounter one so strong that an even better no-load alternative couldn't be found. And with funds of the no-load persuasion, every penny you invest goes to work for you. That isn't true with load funds, whose returns -- at least as they're reported by most financial media services -- typically don't reflect the impact of the sales charges. With load funds, then, what you see isn't necessarily what you get.

Last but not least
One other potential fund cost you need to know about is the early-redemption fee, which some fund companies charge if you trade quickly in and out of their funds. These fees can be as high as 2%, and while no one is a bigger investing cheapskate than I am, I'm a big fan of this variety of 'em.

Why so? Well, for starters, redemption fees deter short-timers from entering a fund to begin with, which is good for buy-to-hold types like us. In-and-out trading can cause managers to buy and sell stocks at inopportune times, racking up hefty transactions costs along the way.

Beyond that, unlike loads and expense ratios, redemption fees are returned to the fund itself as a way of compensating long-term shareholders for the costs associated with their less-patient compatriots. All told, then, while the word "fee" generally gives me the willies when it comes to investing, early redemption fees really do serve the interest of serious, long-term investors.

So that's the skinny on the major fund fees. In our next installment, we'll tackle the not-so-musical question: What's the best way to invest in mutual funds? If you'd like to read this guide's first installment, it's here.

Shannon Zimmerman is the lead analyst for Champion Funds. He owns shares of Vanguard Total Stock Market. The Fool has a strict disclosure policy.


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