Do you know how much you are paying in mutual fund fees? You should, because fees matter . . . a lot.
When you hear people talking about mutual fund fees, they are usually talking about the expense ratio. This is the percentage charged against the earnings of your fund each year. These fees pay the operating costs of running the fund and, usually, return a bit of profit to the company running the fund.
My focus in this article is going to be on this expense ratio.
But you should know about other fees so you can avoid them:
Some funds charge loads–either when you purchase the fund (front end load) or when you sell the fund (back end load). These loads typically compensate the financial advisor who sold you the fund. There is no good reason to purchase a fund with a load. There are too many great funds available that do not have this fee–I would question the motivation of someone trying to sell me a fund with a load.
Funds used to charge 12b-1 fees which were basically so existing fund owners could pay for the company to market the fund to new, potential fund owners. Again, there is no reason to buy a fund with a 12b-1 fee.
We don’t see a charge on our account statement for the expense ratio because the gains or losses on the fund already have the fees removed. If we want to know what the fee is, we need to look on our brokerage’s website or Morningstar.com.
Mutual funds are either passive (index) funds that track a stock index like the S&P 500. Or they are active funds where the stocks are picked by managers.
Active funds need to stay up to date on changes in each company’s prospects and they need a manager to make decisions on what stocks the fund should own. The fees reflect this high level of touch–the average managed fund fee is 1.2% annually or $12 for each $1,000 invested.
Index funds don’t need research departments or star fund managers, they just need a computer program to keep the fund’s stocks aligned with the selected index. This low level of touch comes with a lower fee–the average index fund fee is .51% annually or $5.10 for each $1,000 invested.
Now you might think that you get what you pay for. That 1.2% fee shouldn’t matter because that star fund manager is going to get us larger returns than the computer. Unfortunately, in most cases, you’d be wrong. The star fund manager usually costs us more, and delivers less.
Fund earnings are compared to the performance of a benchmark index each year. This allows us to see how our fund is doing against the entire class of stocks that our fund invests in.
Last year, only about 30% of those star managers did better than the computer. Over the last five years, only 17% of those star managers beat the computer. So most of us paid more . . . for less.
You might not think these small differences in fees matter–but they have a huge impact over a lifetime of investing.
How does this impact a typical investor? Let’s say Susie invests in a fund with the S&P 500 as the benchmark index. She invests $1,300 a year starting at age 25 and increases the amount invested by 2% each year as she receives raises. If she invests in one of the lowest cost index funds, she will have over a million dollars at age 65! If she invests in the average managed fund, she’ll have just over $700,000. She’s lost over $300,000 to fees. And this doesn’t take into account that the managed fund is very likely to have grown less than the index.
Look at your funds’ expense ratios. Compare them to the other funds available to you. Is there a fund that has a similar investment strategy but with a lower fee? Compare your fund’s performance to the other fund over the long-term (5 or 10 years) and compare the Morningstar.com ratings.
If another fund looks more attractive than the one you’re holding, consider switching funds. But BEWARE:
- If you are doing this in a taxable account (rather than a retirement account–IRA, 401k etc.), this may trigger capital gain taxes.
- If you are doing this in a retirement account and are switching brokerages, contact customer service so the funds are transferred properly and don’t trigger a taxable distribution.
- Do not chase performance! It is tempting to move to the fund that has the best, recent performance. But that fund may invest in stocks that have been in favor recently or it may have more risk than the fund you are in. Asset allocation matters-my article on investing may help you avoid some missteps.
Investing is risky, this reflects my opinion and is for informational purposes only. Proceed with caution, do your research and seek professional advice if necessary.