An astounding 74% of fund investors surveyed last year stated that expense ratios are the most important factor they look at when analyzing funds. At the same time, stock fund expense fees dropped to an average 1.07% from the 1980 average of 2.32%, according to a recent Investment Company Institute study.
In other words, mutual fund managers have responded to investor demands. Way to go, fund geeks!
Alas, nobody's perfect
Unfortunately, there's a factor that fund investors have been overlooking that can negate the lowered fees: the turnover ratio. When you own a fund outside of a tax-sheltered account, your returns take a governmental beating when the manager makes too many sales.
Vanguard Group's Bogle Financial Markets Research Center reported that fund turnover has increased significantly in the past 30 years -- from 30% in 1976 to 65% last year. This high turnover percentage is like adding 0.6% annually to your fund's expense ratio, according to Vanguard Group founder John Bogle.
It's important to hold funds like these in an IRA or a 401(k). If you don't, your gains will be accompanied by a hefty bill from Uncle Sam come tax time.
Lots of pain, little gain
Let's look at Value Line Larger Companies (VALLX), a fund with decent trailing returns but an astronomically high annual turnover rate of 203%.
The fund invests in large-cap growth stocks -- Amazon.com (NASDAQ:AMZN), EMC (NYSE:EMC), Research In Motion (NASDAQ:RIMM), Google (NASDAQ:GOOG), Nike (NYSE:NKE), and Cisco Systems (NASDAQ:CSCO) are all among the top holdings. And while this segment of the market has been good to investors of late, Value Line's strategy would have taken a big chunk out of your returns if they weren't tax-sheltered.
While the fund's three-year annualized return at the end of July (14.96%) was better than the market's, an investment would have only grown by 10.63% annually after paying taxes on the realized gains, according to data from Morningstar.
Four percentage points?!
Here's a look at how a $50,000 investment would look over time -- before and after taxes -- assuming the fund's continued three-year annualized return:
|
Before Taxes |
After Taxes | |
|---|---|---|
|
After 10 years |
$201,575.41 |
$137,309.04 |
|
After 20 years |
$812,652.93 |
$377,075.44 |
|
After 30 years |
$3,276,216.99 |
$1,035,517.34 |
The difference in these results is startling -- and becomes even more so over longer periods of time. In the end, you could save some $2 million simply by taking advantage of the tax-sheltered vehicles, such as IRAs and 401(k) plans, available to you!
The drawbacks of shelter
The IRS places limits on the amount you can contribute to these accounts. Currently, you can save up to $15,500 annually in your company's 401(k) -- or $20,500 if you're over 50 years old. The Roth IRA limit is $4,000 ($5,000 if over 50), though there are some income restrictions placed upon it.
Nevertheless, by taking advantage of both accounts, that's nearly $20,000 a year you could be investing in any fund you wish tax-free. And if you have more to save than that, make sure to keep low turnover funds in your taxable accounts.
Bottom line
We're stoked that investors are starting to demand a fair price tag for their funds. But when other factors are ignored -- like the turnover ratio -- your returns can quickly disappear.
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Fool analyst Adam J. Wiederman owns no securities mentioned above. Amazon.com is a Stock Advisor recommendation. The Fool's disclosure policy pays no taxes on its investments.
