For mutual fund investors, it all comes down to costs.
Over the past 10 years, the average domestic stock fund returned 8.19% a year, while the Standard and Poor's 500 returned 10.04% annually. The 185-basis point difference can be mostly attributed to the costs that funds incur -- an average 152 basis points -- that the S&P 500 doesn't. This also explains why index funds, which charge as little as 18 basis points a year, beat most actively managed funds over the long term.
Even the recent mutual fund scandals come down to costs. When mutual fund families allow privileged investors to actively trade or "late trade" mutual funds, the practical effect on regular shareholders is greater trading expenses and higher turnover (which could lead to higher taxes). As stated in yesterday's Wall Street Journal editorial, "This isn't the worst financial scandal of all time, but it is singular in that it has directly taken money out of the pockets of so many Americans." Fool Rex Moore (TMF Orangeblood) cited a recent study that concluded that late trading costs mutual fund investors $400 million a year. According to the Journal, estimates of the cost of market timing to long-term investors run as high as $5 billion.
The more investors know about the costs of owning a fund, the better. Which is why a recent announcement from Vanguard is welcome news. The second-largest mutual fund family will begin devoting a full page in its shareholder reports to a discussion of fund operating expenses, including a table that shows the dollar cost an investor would incur over the fund's latest fiscal year assuming a $10,000 investment. The new format is based on a Securities and Exchange Commission rule proposed in December 2002 that has not yet been enacted.
According to a Vanguard spokesman, mutual funds are required in their prospectus fee tables to show the cost in dollars of investing $10,000 over 1-, 3-, 5-, and 10-year periods, assuming a 5% return. Vanguard's shareholder reports, however, will use actual costs and returns and present the information in a more reader-friendly format.
Of course, Vanguard has a significant interest in getting the mutual fund industry to be more up front about expenses. The Valley Forge, Pa., company -- the creator of index funds -- is known for keeping costs down without compromising performance.
According to Morningstar, of the 20 domestic stock funds that beat the S&P 500 over the past 10 years and had an expense ratio below 0.50%, seven come from Vanguard. A close second goes to GMO funds, which had five of the 20. What, you've never heard of GMO? Perhaps that's because you're either not an institutional investor or you're not filthy rich, since most of their funds have $5 million investment minimums. However, GMO does sub-advise funds with much smaller investment minimums, which are offered by Evergreen, Calvert, and -- guess who -- Vanguard.
The bottom line: Investors don't need to pay a lot for a good mutual fund. In fact, according to an S&P study, funds with lower expense ratios tend to outperform their more expensive peers.
For more on finding the best funds, visit our Mutual Fund center. And for a quick introduction to index investing, read our 60-Second Guide.
