The High Cost of Mutual Funds?

“Most People, Brokers and Mutual Funds Do Worse Than Average.” You may have heard this or similar message.  It is difficult to “beat the market.” The averages are just that – theoretical, numerical averages with no brokerage commissions, no fees, and no taxes.  This artificial measuring stick does not exist in reality!

Also consider what “market” you are trying to beat?  If it is a stock market index, then you are using an artificial measuring stick made up of 100% stocks!  Do you own or want to own 100% stocks?  If your portfolio has any diversification, then you are simultaneously seeking to beat many different markets (Large cap stocks, Small cap stocks, International stocks, Bonds, Commodities etc. etc. etc.).

What Counts Is How Well You Do After Costs!

In deciding among thousands of mutual funds to own, or whether to keep one you already own, ignore last year’s sizzling performance, the “star” ratings and magazine covers that scream “The 10 Best Funds to buy NOW!”  Look past the marketing hype.

. . . Because Predicting Costs Is Much Easier than Predicting Performance

While the popular press will no doubt continue to glamorize the best-performing mutual fund managers, the mundane explanations of strategy and investment costs account for almost all the important predictability in mutual fund returns.

In short, the familiar disclaimer that “Past performance cannot guarantee future results” should really read, “Past performance is largely useless in predicting future results.”  Except when it comes to costs.  However, do you know how costs are determined?

There are four basic kinds of costs associated with owning mutual funds:

Fund Management Fees

These are paid to the fund company that manages the mutual fund.

Distribution Fees

These are paid to the broker or adviser that sells the fund and services the account.  In some cases, it’s an up-front sales commission (“load”) or a surrender fee you pay when you sell the fund. But other funds – “no-loads” – may charge an annual “12b-1 fee.” In still other cases, the fund manager simply uses part of its management fee to pay for marketing and distribution. You thought that hefty fee was going to a team of brilliant analysts, but some of it may go to pay broker commissions or buy ads.

Transaction Costs  (What’s Not In the Published “Expense Ratio”)

These are incurred by the fund as it buys and sells securities. Trading costs money, and it comes out of your money.  Sometimes, to keep its reported management fee low, a fund will pay for investment research with what are called “soft dollars” – higher commissions than they might otherwise have to pay.

Beyond commissions, there are spreads. A spread is the difference in the share price you pay to buy a security and the share price to sell the same security at the same time.

Mutual fund managers are generally sensitive to this, of course, and attempt to trade cheaply and wisely. Generally, a fund with 100% annual turnover gives up nearly 1% in transaction costs. A fund with 25% turnover would give up only a quarter as much. A fund with 300% turnover – three times as much.

Transaction costs are not incorporated in a fund’s “Expense Ratio.”

Taxes (Also not a part of the “Expense Ratio”)

The fund itself does not pay taxes.  Shareholders who own the fund in taxable accounts pay taxes on dividends and capital gains distributed by the fund. Many clients view dividends and distributions positively, so a manager may realize gains unnecessarily. This may be good marketing, but it’s bad financial strategy.

Fund Managers know the public is much more focused on their mutual fund rate of return than they are on taxes caused by a mutual fund.  A Fund Manager is not going to cater their decisions to your tax situation as an individual investor.

Why work with an experienced, fee-based, Fiduciary Advisor?

#1 reason is the knowledge gap.  A person doesn’t know what they don’t know, and there is a lot to know in this fast-moving industry.

#2 reason is the Advisor’s financial incentive is the same as your financial incentive.  Every expense affects your Fiduciary advisor the same way you are affected.

#3 reason the freedom and convenience knowing your best interests are being served without having to study everything or “mind the store” as a person might feel working with a commission-based, Non-Fiduciary broker.

 

 

Information sourced from PersonalFund.Com