Nothing infuriates Fools more than Wall Street fat cats who take as much of our money as they can in exchange for minimal work. Sometimes it's easy to separate the good from the bad, but many of us are a bit lost when it comes to the world of mutual funds. Is there a way to know whether we're getting what we paid for?
Fortunately, there is. Today I'll walk you through a short checklist to determine whether your mutual fund manager really cares.
No. 1: Ugly fees
This is the obvious place to start. Shannon Zimmerman, who heads up Motley Fool Champion Funds, tells us that the expense ratio for the average domestic fund is just shy of 1.5%. If your fund is charging significantly more than that (say, 1.75% or higher), your ability to earn outsized gains over the long haul is severely hampered.
To illustrate, let's consider two S&P 500 index funds with a 0.4-percentage-point difference in expense ratios (0.1% versus 0.5%). Their holdings are the same, consisting of stalwarts such as General Electric (NYSE:GE), ExxonMobil (NYSE:XOM), and Citigroup (NYSE:C). Yet if each earned average annual gains of 10% (before fees) for 30 years and you invested $4,000 per year, the pricier fund would rob you of $53,000. And after 44 years, your loss will have grown to $328,000!
No. 2: Rising assets, falling ratios
This is one heck of a way to see whether your manager likes you. The more money a fund has under management, the lower the expense ratio it needs to charge. Reputable fund families tend to lower expense ratios as assets under management rise -- as well they should. After all, the greater the assets, the more shares there are to spread those fees across. Economies of scale matter for Wal-Mart (NYSE:WMT) because its giant size allows it to buy goods for less and to operate more efficiently. The same principles apply as a fund grows.
No. 3: Insider ownership
Does your management team have a significant amount of its own money invested in the fund? There's no better indicator that management's interests are aligned with shareholders than high "insider ownership." Shannon has interviewed 10 managers he rates at the all-star level, and they almost all mentioned the importance of eating their own cooking.
Neil Hennessy, for example, has his entire retirement package in his shop's funds. That lineup includes the Hennessy Focus 30 (HFTFX), a top performer in 2005 that counts the likes of Express Scripts (NYSE:ESRX) and JLG Industries (NYSE:JLG) among its biggest holdings. Chip Carlson says his Greenspring Fund (GRSPX) -- a successful, off-the-beaten path hybrid offering whose predominantly small-cap equity holdings include SuncorEnergy (NYSE:SU) -- is probably the largest holding for his entire staff.
No. 4: Asset bloat
Beware of the dreaded "asset bloat." For smaller-cap funds in particular, it's crucial that a manager is able to trade nimbly among the kinds of names he or she likes without having an adverse impact on the stock price -- i.e., moving that price up as the manager tries to build a position and down when trying to exit one.
With that in mind, Shannon is a big fan of fund shops that are willing to forgo the additional fees they'd rake in with a bigger asset base. Instead, these fund shops choose to protect the manager's ability to execute his strategy effectively for current shareholders.
Foolish bottom line
Overinflated fees. Shareholder-unfriendly management with little or no stake in the fund. Asset bloat. These are signs your fund manager hates you -- or at least cares more for his returns than yours.
Of course, if you find a reasonably priced fund headed by an experienced manager whose personal wealth is tied up in that fund, you're miles ahead of the game. And this is what Shannon searches for each and every day for his Champion Funds members. Thus far, the results are gratifying, with his recommendations achieving total average returns of 22% versus the market's 10% since the service began two years ago. If you'd like a full-access pass to the newsletter free for 30 days, click here for more information. There's no obligation to subscribe.
Rex Moore once swallowed 27 goldfish in five minutes. The cheddary Pepperidge Farm kind, of course. He owns no companies mentioned in this article, a fact brought to you by the Fool's minty disclosure policy.
