Mutual Funds & Fees

by Tom Gardner

ALEXANDRIA, VA (Sept. 29, 1998) -- The economics of the world have been roiled this summer, with reports of unhappy regress from every corner of the globe.

In Russia, the default on $17 billion in loans has sent the economy, such as it was, into chaos. In Japan, where the stock market is more than 60 percent off its highs in the early 1990s, the Chief of Economic Planning recently forecast the fourth consecutive quarter of negative growth, and confesses, "I see no sign of recovery." And on a single day in early September, Brazil, the largest economy in Latin America, hiked its interest rates from 30% to 50%.

And the economic instability is beginning to impinge on the U.S. markets.

This past week, the inappropriately named Long Term Capital Management Hedge Fund announced that its gambles on the short-term direction of foreign markets had, in less than eight weeks, resulted in losses of over $3.5 billion, or 90% of its value. And today, even after flashes of greatness in 3rd-quarter earnings reports, the U.S. market is off 13 percent from its summer highs. Market bellwethers and Warren-Buffett collectibles, Coca-Cola, Gillette, and American Express, are all off more than 30 percent.

Right about now, with the homerun derby done, and evidence that interest in the White House scandal is subsiding, more investors than at any point this decade are taking stock of the performance of their portfolio, measuring out their actual returns against the assumptions in their retirement plans, and trying to figure out whether to make any changes. With $5 trillion invested in the mutual-fund industry in America, investors are, first and foremost, casting their eyes on the bottom-line returns on those monthly mutual-fund statements.

What they're finding, if they're able to sort through it all, is pretty startling.

Lipper Analytical Services in New York reports that over 90% of all general-equity funds have underperformed the market's average return over the past five years. Worse still, in 1998, more than 95% of all stock funds have been worse than average. The industry over the past decade has more resembled the Tampa Bay Buccaneers than the second stringers on the San Francisco 49ers. Mutual funds are being lit up in comic strips, in editorials, even in the magazines and newspapers that rely on them for advertising.

What many investors may be overlooking, though, when they focus so tightly on the short-term performance of their funds is the profoundly negative impact that mutual-fund fees can have on investments over the long haul. Consider some basic numbers. A $25,000 investment in the average mutual fund today will incur 1.75% annual management fees, or $438 in the first year. But as that investment grows, the 1.75 percent annual expense ratio will lop off far greater amounts of money. After thirty years of 10% annual growth, the investor in this average fund will be paying over $5,200 in annual fees to carry the position.

When you match this up to the fact that the great majority of funds have been doing worse than average over the past 1-, 5-, 10-, and 20-year periods, the fees become even less justifiable. In open markets, expensive underperformance is a temporary thing -- whether we're talking about personal computers, automobiles, athletic equipment, or mutual funds.

Which leads me to the only mutual-fund recommendation that I ever expect to make in my life -- the same as it's been in each of our investment guides: the Vanguard S&P 500 Index Fund, and its siblings at other mutual-fund families. Consistently among the least-expensive funds on the market, since it's mechanical approach is managed primarily by computer, the S&P 500 Index Fund also has outperformed nine out of ten managed funds this decade.

Run some simple numbers, the differences are startling.

With an annual expense ratio of 0.20%, or eight times less than the industry average per year, the index fund saves the average investor a tremendous amount of money. After thirty years of 10% annual growth, a $25,000 investment in the Vanguard Index Fund will charge its shareholders just over $1,000 to carry their positions, more than $4,000 less than the managed stock fund.

But what about the final overall returns?

Even giving the managed stock fund the benefit of the doubt on performance and setting it at the same rate of return as the index fund, its fees destroy the returns. After thirty years of 10% growth, the $25,000 parked in the S&P Index Fund has accumulated $235,000 more than the same amount invested in an above-average managed-stock fund. The average mutual fund's investment underperformance and higher fees make it doubly less attractive than the plain vanilla index.

Folks across the country are beginning to learn this. As they look over their accounts this autumn and into the New Year, wondering what to do, and as they watch the foreign markets weebling and wobbling about, they'd do well to scrutinize both the performance of their mutual funds and the fees tied to those funds -- a task that will take no more than an hour. Then they'd do well to compare those results to the simple S&P 500 Index Fund -- taking another fifteen minutes. It's likely they'll find that the index fund has, with the force of a freight train heading downhill, consistently and dramatically outpaced the returns offered by a mutual fund family's managed-fund selections.

If they need help in this process, please feel free to forward this report to them and/or to encourage them to post questions to our message boards. Finally, if their or your 401k plan doesn't include an index fund option, your plan administrator needs to understand why that's a problem with the plan.

Fool on,

Tom Gardner

Cash-King Strategy Folder
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09/29/98 Close

Stock  Change    Bid 
 AXP   -2 1/8   80.88 
 CHV   +3 1/4   88.00 
 CSCO  -1 5/8   64.63 
 KO    +1 9/16  58.69 
 GPS   +  1/4   52.75 
 EK    -1 3/16  77.94 
 XON   +3 3/16  71.25 
 GM    -1 1/2   58.00 
 INTC  +1 1/2   88.50 
 MSFT  +1 9/16  112.88 
 PFE   +  3/4   106.81 
 SGP   +2 5/16  107.06 
 TROW  -  5/8   30.00 
                 Day     Month    Year    History 
         C-K      +0.61%   9.91%   8.31%   8.31% 
         S&P:     +0.03%   9.55%   4.28%   4.28% 
         NASDAQ:  -0.30%  15.66%   4.06%   4.06% 
 Cash-King Stocks 
     Rec'd    #  Security     In At       Now    Change 
     2/3/98   24 Microsoft     78.27    112.88    44.21% 
     2/3/98   22 Pfizer        82.30    106.81    29.79% 
    6/23/98 34.5 Cisco Syst    57.56     64.63    12.27% 
    8/21/98   22 Schering-P    95.99    107.06    11.54% 
    2/13/98   22 Intel         84.67     88.50     4.52% 
     5/1/98   37 Gap Inc.      51.09     52.75     3.25% 
     2/6/98   56 T. Rowe Pr    33.67     30.00   -10.91% 
    2/27/98   27 Coca-Cola     69.11     58.69   -15.08% 
    5/26/98   18 AmExpress    104.07     80.88   -22.29% 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko    63.15     77.94    23.42% 
    3/12/98   20 Exxon         64.34     71.25    10.75% 
    3/12/98   15 Chevron       83.34     88.00     5.59% 
    3/12/98   17 General Mo    72.41     58.00   -19.90% 
 Cash-King Stocks 
     Rec'd    #  Security     In At     Value    Change 
     2/3/98   24 Microsoft   1878.45   2709.00   $830.55 
     2/3/98   22 Pfizer      1810.58   2349.88   $539.30 
    8/21/98   22 Schering-P   2111.7   2355.38   $243.68 
    6/23/98 34.5 Cisco Syst  1985.95   2229.56   $243.61 
    2/13/98   22 Intel       1862.83   1947.00    $84.17 
     5/1/98   37 Gap Inc.    1890.33   1951.75    $61.42 
     2/6/98   56 T. Rowe Pr  1885.70   1680.00  -$205.70 
    2/27/98   27 Coca-Cola   1865.89   1584.56  -$281.33 
    5/26/98   18 AmExpress   1873.20   1455.75  -$417.45 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko  1262.95   1558.75   $295.80 
    3/12/98   20 Exxon       1286.70   1425.00   $138.30 
    3/12/98   15 Chevron     1250.14   1320.00    $69.86 
    3/12/98   17 General Mo  1230.89    986.00  -$244.89 
                               CASH     $48.07 
                              TOTAL  $23600.70 
 *Please note: On 8/4/98 $2,000 cash was added to the
portfolio for future investment. This will be reflected
in the numbers as soon as possible.

*The year for the S&P and Nasdaq will be as of 02/03/98