Mutual Fees Is Thievery

Financial Petty Thievery

By Tim Hanson (TMF Mmbop)

 

 

Fees are the bane of investors. The more you pay up front, the less you make down the line. But fees are also a fact of life. Whether you invest in mutual funds or equities, someone somewhere who's not you is getting a cut.

 

The key is to minimize fees without affecting performance. And when you keep fees down, you'll be surprised how much your long-term performance can improve.

 

Know your fees

When looking for mutual funds, there are a few kinds of fees to be aware of.

 

Fee

 Definition

 

Expense Ratio

 The percentage of your assets a fund uses each year to pay for operations such as trading costs, taxes, salaries, and services.

 

12b-1 Fee

 An extra expense charged by some mutual funds to pay for promotion and marketing.

 

Front-end Load/Purchase Fee

 A sales charge added to the cost of purchasing shares of a fund.

 

Deferred Load/Redemption Fee

 A fee imposed upon selling shares of a fund.

 

 

 

Fees are a fact of life, but not all fees are equal. Expense ratios exist at every fund -- from the most staid index to the most actively managed micro-cap fund. They do, however, vary. Vanguard Total Stock Market (FUND: VTSMX), a passively managed fund that tracks the MSCI U.S. Broad Market index, and Fidelity Spartan Total Market (FUND: FSTMX), which tracks the Wilshire 5000, charge shareholders just 0.19% and 0.10% per year, respectively. Matterhorn Growth, on the other hand, charges approximately 3.2%. Of course, Matterhorn has only $4 million worth of assets under management, so the good news is that most investors realize what a raw deal 3.2% is.

 

When taking a look at expense ratios, be sure to compare your fund with the category average. Some fund categories are necessarily more expensive than others. Yet as with the stocks, the important thing is to always compare apples with apples.

 

Funds with loads and 12b-1 fees also tend to be raw deals for investors. There is only one fund in Fool fund guru Shannon Zimmerman's portfolio of Champs that charges this fee, and it's a bond fund, where pickings can be slim. Moreover, even with the fee, this fund has a total expense ratio of less than 1% -- 26 basis points below the category average.

 

But loads and 12b-1 fees are generally grounds for disqualification from Motley Fool Champion Funds consideration. The reason: There's always a cheaper fund out there that's just as good, if not better. (It's not a coincidence that great managers and low fees tend to go together.) In fact, the only way load funds can find their way into the pages of Champion Funds is as a Dud of the Month -- a fund that discerning investors would be wise to avoid.

 

The effect of fees

Take a look at how higher-than-average fees can erode a portfolio over time. Even after just 10 years, the effect is profound. For the sake of comparison, we'll take a large-cap core Champ and compare it to the category average and a Dud.

 

Fund

 Expense Ratio

 $10,000 in 2011

 $10,000 in 2016

 

Champ

 0.85%

 $9,582

 $9,182

 

Category Average

 1.50%

 $9,272

 $8,597

 

Dud

 1.78%

 $9,141

 $8,356

 

 

 

Assuming no capital gains or losses, the Dud will cost you an extra eight percentage points. But that's not realistic. The more expensive fund should do better, right? Not according to each fund's track record. While the Champ has thumped the category average to the tune of seven percentage points over the past five years, the Dud has actually been in the red -- trailing the average category performance by three percentage points.

 

What's worse, the Dud even carries a front-end load of 5.5%! That means it will charge you $550 right off the bat (on a $10,000 investment) for the privilege of owning this loser. Those fees put Dud investors at a disadvantage even if the Dud and the no-load Champ were to own the same basket of stocks, which they don't. While the Dud has struck out this year with top-10 holdings like Verizon (NYSE: VZ) and Pfizer (NYSE: PFE), the Champ has profited handsomely from Arch Coal (NYSE: ACI), Goldman Sachs (NYSE: GS), and KB Home (NYSE: KBH).