Mutual funds are a beautiful device. With a single purchase, investors can be part owner of a collection of hundreds of investments, allowing them to have diversified portfolios, even with a modest investment of less than $1,000.
Asset management isn't a not-for-profit business, however. The industry thrives on fees, which transfer wealth from mutual fund investors to mutual fund managers.
Here are three signs your mutual fund is hosing you, transferring wealth from your pocket to theirs.
Take a load off your back
Nothing irks me more than loaded mutual funds. A load is a fee you pay when you buy or when you sell a mutual fund.
The most egregious cases involve fund companies that charge up-front loads of 5% or more. If you invest $10,000 into a fund with a 5% load, $9,500 will go to your investments. The $500 load -- 5% of your investment -- will go to the broker and the fund company.
Some so-called "experts" recommend that individual investors buy loaded mutual funds. The idea is that the load is a behavior device -- if you pay a load to buy a fund, you'll be less likely to sell your funds and pay another load in the future.
Such advice is rooted in the same logic that you should poke out an eyeball to understand why you'd never want to go blind. You could never convince someone to spare an eyeball to understand the cost of blindness, but whole convention rooms full of investors have been convinced that paying a load is in their best interest. It isn't.
To call a spade a spade, a 12b-1 fee is a fee investors pay a mutual fund for marketing. The proceeds of the fee are often divided between the fund company and brokers, who effectively earn a "kickback" for selling mutual funds to their clients.
The cost of 12b-1 fees is significant. At 0.25% per year, the cut-off at which a fund can call itself a "no-load fund," 12b-1 can add up to tens of thousands of dollars in lost growth over the long haul. For advisors, it represents a highly profitable fee stream on which brokers get rich on the backs of savers.
Read the fund company's prospectus carefully. If you're paying a 12b-1 fee, you're probably getting hosed.
Turn and churn
Mutual funds used to be largely passive entities. Managers would identify their best ideas, make investments, and wait. Waiting, after all, is 99% of the investment process.
Today, however, funds are turning over their investments at a faster clip -- some 85% of their portfolio holdings each year, on average. The end result is that turnover creates significant tax consequences. This year, a number of fund companies distributed big capital gains distributions to their clients.
If your mutual fund has a high turnover ratio, you're probably getting hosed. Not by the fund company, but certainly by Uncle Sam. And your mutual fund manager is entirely to blame.
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