You're Paying How Much?

Last week, we began our look at the criteria I consider when selecting funds for the new Motley Fool Champion Funds newsletter service. (You can give that service a whirl -- for free -- if you're so inclined). Market-beating performance and plenty of managerial experience, you'll recall, are near the top of my list when I begin searching for the best and brightest the mutual fund industry has to offer.

As important as those attributes are on their own, even together they are not enough. No, in addition to the right performance stuff and a well-seasoned manager (I like tarragon and cilantro myself), I need to see a reasonable expense ratio. As my wife will be only too happy to tell you, I am a dyed-in-the-wool cheapskate. I'm just not willing to pay through the nose (or any other body part for that matter) for a mutual fund.

The price you pay
Actually, it's not just my miserly ways that cause me to focus on a fund's price tag. Fact is, when you're trying to get a bead on a fund's future prospects, few attributes have more predictive power than the expense ratio. Which only stands to reason. A high price tag puts a fund at a distinct disadvantage, giving the fund's manager more ground to make up each year just to stay competitive with cheaper rivals. Conversely, a reasonable price tag gives a fund a head start, fattening the bottom line (i.e., your return) year after year.

But what, exactly, is a fair price to pay for a mutual fund? Good question. On some level, expenses are relative. All things being equal, if the typical stock fund's expense ratio will ding you about 1.5% per year -- and it will -- anything less is reasonable, at least comparatively speaking. On the other hand, all things aren't equal. And with alluringly cheap index options such as Vanguard Total Stock Market (VTSMX) there for the taking, a fund generally needs to be a good deal cheaper than the average to get my attention. Indeed, I'm a big fan of expense ratios that fall below 1%. That's an arbitrary number, sure, but at least it's arbitrarily low.

Exceptions to the rule
That said, I am willing to consider pricier fare. If a terrific manager opens a new fund and, owing to its initially small asset base, that fund costs a little more than I'm used to paying, I'll still give it a look. As the fund grows in size, though, I'll certainly expect to see its expenses come down. If you own a fund whose asset base has ballooned while its expense ratio has stayed high -- cough, cough, Federated Kaufmann Fund (KAUFX) -- you might consider selling. Economies of scale just make things cheaper, and with more dollars available from which to deduct fees, the hit each individual investor takes (in the form of the expense ratio) ought to decrease as a fund's asset base grows.

A performance-based management fee is another reason I'll consider paying up for a fund. I'm a big fan of the way such fees align the interests of managers with those of their shareholders. Indeed, I like that aspect of them so much that I -- penny-pincher that I am -- recently wrote favorably in Champion Funds about a fund with a price tag of 1.9%. In fact, that figure looks positively cheap relative to the margin by which the fund has outperformed the S&P 500 since its inception. And make no mistake: If and when that streak of out-performance ends, the fund's expense ratio will head south posthaste. C'mon, you just gotta love that.

Exceptions that prove the rule
On the other hand, sometimes a fund that looks cheap really isn't. Consider the case of Fidelity Magellan (FMAGX), which is currently closed to new investors. At just 0.72%, you might think this celebrity fund is going for a song. Think again. Over the years, Magellan's massive asset base has more or less caused the fund to become increasingly conservative, so much so that it's now basically a closet S&P 500 tracker.

The fund's top holdings look like the VIP section at a blue-chip party: Citigroup (NYSE: C  ) , AIG (NYSE: AIG  ) , General Electric (NYSE: GE  ) , Microsoft (Nasdaq: MSFT  ) , ExxonMobil (NYSE: XOM  ) , and Fannie Mae (NYSE: FNM  ) were all among Magellan's top holdings at the end of 2003. Who needs to pay a premium for that, particularly when you can buy Fidelity's own S&P tracker, Spartan 500 (FSMKX), for a mere 0.19%?

The bottom line
Fund expenses are more than just the price you pay to invest. When you get right down to it, they're a part of the fund itself, a feature of the product you're buying. How could it be otherwise? Expenses have a direct impact on the fund's relative and absolute performance, and simply put, to the extent that they're lower, your fund is likely to do better.

It's also more likely to make the grade as a champ. To be sure, no single attribute -- price tag included -- is sufficient to secure that status. But if I had to choose only one data point to consider before making a call as to whether a fund is likely to beat the market over time, the expense ratio is the first place I'd look.

The good news is I have a plethora of data to consider when making my picks, not to mention a bounty of qualitative factors. We'll take a closer look at those next time.

Shannon Zimmerman leads the charge onMotley Fool Champion Funds, a newsletter service dedicated to separating the fund industry's wheat from its chaff. Shannon owns shares of Vanguard Total Stock Market Fund: Don't you? The Fool has a disclosure policy.


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