How Much Is Management Costing You?

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Some mutual funds give their shareholders everything they ever hoped for. Most, however, fall way short.

If you hang around Fooldom a bit, you'll run across references to mutual funds, and they'll often be rather respectable ones. Here are a handful:

Fund	10-Year Avg. Annual Return	Recent Top Holdings Include
Fidelity Contrafund (FCNTX)	3.6%	Gilead Sciences (Nasdaq: GILD), Medco Health Solutions (NYSE: MHS)
Fidelity Low-Priced Stock Fund (FLPSX)	10.9%	Abercrombie & Fitch (NYSE: ANF), Johnson Controls
CGM Focus (CGMFX)	19.1%	Goldman Sachs (NYSE: GS), CME Group (NYSE: CME)
Homestead Value (HOVLX)	3.9%	Abbott Labs (NYSE: ABT), Marathon Oil (NYSE: MRO)
S&P 500 Index fund	(1.0%)	All of the above

Data: Morningstar.com.

Here's the thing, though: These funds are in the minority. Most mutual funds -- and there are thousands -- are not that spectacular. Most of the 4,700 or so stock funds out there lose to the S&P 500 over long periods.

But don't take my word for it. Consider the recent words of David Swenson, who has managed Yale's multibillion-dollar endowment very successfully over the long haul: "The problem is that the quality of the management in the mutual fund industry is not particularly high, and you pay an extraordinarily high price for that not-very-good management."

Moreover, Swenson cited a 20-year study of mutual funds conducted by market researcher Robert Arnott that found that after you account for fees and taxes, you'd have just a 15% chance of beating the market in mutual funds. Yikes. And making matters worse, the study excluded the many funds that closed over those years, due to poor performance. If their results had been factored in, the results would be bleaker.

Digging deeper
We often ignore the effect of fees and taxes, to our detriment. Imagine three mutual funds, with annual expense ratios of 0.5%, 1%, and 1.5%. Consider how a $10,000 investment would grow in each of them over 25 years if each earns 10%, pre-fee (leaving you with annual returns of 9.5%, 9%, and 8.5%):

Growing at ...	In 25 Years Becomes ...
8.5%	$76,870
9.0%	$86,230
9.5%	$96,680

That's a difference of almost $20,000 -- based on an initial $10,000 investment! All from a seemingly small difference in fees.

The lesson here is simply to be picky. Look at fees. Look at a fund's turnover, because the higher the turnover, the higher the taxes on gains will likely be. Look at the long-term returns, too, because given the thousands of mutual funds out there, many are run by not-very-good managers.

Get another perspective on mutual funds from Foolish fund expert Amanda Kish. Read why she thinks these investments will lose money.