Don't Be Suckered by These Investments

There are lots of things I love about mutual funds: their convenience, diversification, expert management, and (sometimes) solid performance. But if you're not careful, the wrong funds could cost you far more than you ever wanted to spend.

Too many investors cough up too much in fees to the funds in which they invest. The folks at kaChing run a portfolio management service in which you can replicate the portfolios of high-performing members. They found that on average, mutual funds charge their shareholders more than 3% annually. That should surprise you; most funds quote expense ratios between 1% and 2%. But those yearly expenses aren't always the only fees involved.

The fees you don't see
kaChing detailed the following undercover costs:

Fee

Average Actively Managed Mutual Fund

Management fee

0.69%

Trade commissions

0.10%

Soft dollar commissions

0.10%

Marketing fee

0.53%

Other expense fee

0.47%

Front-end load

0.32%

Back-end load

0.22%

Other investors' tax liability

0.94%

Total

3.37%

Source: kaChing.

These are averages, of course. Many funds charge no sales load at all, while those that do sometimes charge nearly 6%! Some funds levy hefty marketing fees, while others charge little or nothing on that front.

Funds often quietly pay commission expenses to brokerages, while the other investors' tax liability reflects the cost, on average, that shareholders bear in taxes due on gains a fund made before they added their money to it. For instance, if you bought into a fund in October, you'll end up with a year-end tax liability as a shareholder on gains the fund realized over the many months before you joined it. Ouch.

Choose your solutions
A 3% or more bite out of our mutual fund performance is a big deal, because every percentage point counts. Imagine two funds whose investments manage to earn 10% over 20 years. One charges 3%, while the other charges 1%. The 3% fee will reduce your annual gain to 7%, turning a $10,000 investment into $38,700. The 1% fee will leave you with 9% and $56,000. See the difference?

Clearly, you can find good funds that charge much less than 3.37%, but you may have to hunt them down. Consider calling the fund company and asking for a breakdown of fees, both listed and unlisted.

You can also minimize your fees (and your labor) and earn nearly the same return as various indexes by investing in inexpensive index funds. For example, here are some lesser-known index funds beyond the S&P 500:

Index Fund

Expense Ratio

10-Year Avg. Ann. Return

Selected Holdings

Vanguard Total International Stock Index (VGTSX)

0.27%

2.1%

Rio Tinto (NYSE: RTP  ) , Total SA

Vanguard Mid-Cap Index (VIMSX)

0.22%

6.0%

priceline.com (Nasdaq: PCLN  ) , Micron (Nasdaq: MU  )

Vanguard Small-Cap Index (NAESX)

0.23%

3.4%

DreamWorks Animation (NYSE: DWA  ) , Oshkosh (NYSE: OSK  )

Vanguard Balanced Index (VBINX)

0.20%

2.8%

AT&T (NYSE: T  ) , Altria (NYSE: MO  ) , various bonds

Data: Morningstar.

If you'd like pointers to high-performing funds -- both managed and index-based -- take advantage of a free trial of our Rule Your Retirement newsletter. You can see our full archive of concise and practical retirement guidance, along with stock and fund recommendations, free for 30 days.

Sharpen your fund savvy with further Foolishness:

Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. DreamWorks Animation and priceline.com are Motley Fool Stock Advisor choices. Total SA is a Motley Fool Income Investor recommendation. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.


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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 February 18, 2010, at 9:03 PM, jgalore wrote:

    Thank you for spreading the word about unfair and hidden expenses associated with actively managed mutual funds.

    You should know:

    1. All the data in our blog came from Lipper and Greenwich. We were just the first to put all the fees together in one easy to understand table.

    2. All expenses quoted in our blog pertain to “actively managed” mutual funds. Therefore it isn’t fair to compare index fund expenses to those of actively managed funds.

    - Jonathan Galore, kaChing

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