Watch out for fund expenses
I love mutual funds. My wife says I sound like a total investment nerd when I talk this way, but I say it without shame or embarrassment. Mutual funds are beautiful and elegant and powerful. From the moment the first mutual fund was launched in 1924, they have allowed millions of people to participate in the capital markets who would never have had the opportunity otherwise.
However, despite my love of mutual funds, I recognize that not every fund is a good investment. Mutual funds can be treacherous territory for the casual investor. Your research should go beyond looking at historical performance and consider the costs associated with owning a particular mutual fund. Some costs are readily apparent; others are less obvious. Here are some things to look for as you do your due diligence.
Perhaps the most visible cost associated with a mutual fund is the fund’s “load” or sales charge. The purpose of the load is to pay the broker who sold you the fund. In today’s market, there are plenty of excellent no-load funds available. If your advisor insists on recommending funds with loads, you probably want to find a new advisor.
You should look carefully at the fund’s expense ratio. The expense ratio measures the percentage of a fund’s net asset value that goes to pay operating expenses. The largest of these expenses is the fund’s management fee, but the expense ratio also includes 12b-1 fees and various legal and administrative expenses.
Actively managed funds generally have higher expense ratios than passively managed funds. For example, according to a Morningstar survey of 2017 expense ratios, the dollar-weighted average expense ratio for an actively managed U.S. equity mutual fund was 0.73% compared to 0.11% for passively managed funds. This is one reason why I tend to favor passively managed funds.
Passive management also reduces other, less visible costs of fund ownership by reducing portfolio turnover. Portfolio turnover is a measure of a fund’s trading activity. The more trading activity in the fund, the higher the fund’s portfolio turnover. Portfolio turnover is typically reported as a percent of net fund assets.
High portfolio turnover increases a fund’s costs in three direct ways. First, funds with higher turnover pay more in brokerage commissions. Second, they tend to suffer greater market impact—especially large funds—as they buy and sell large stock positions in the open market. And third, actively managed funds lose more to the market’s bid-ask spread, or the difference between the price of buying or selling a security. These expenses are subtle and don’t show up explicitly in the standard reports on mutual fund performance, but they have a real impact over time. According to a paper published in 2014 by John Bogle, the late founder of Vanguard funds, these trading costs were estimated to reduce actively managed fund performance by 0.60% per year.
Passively managed funds are also inherently more tax efficient. If the fund is held in a tax-deferred account like an IRA, the tax efficiency of the fund’s management style is of lesser importance. However, tax efficiency is vital in a taxable account. If an active fund manager has 50% turnover and, on average, realizes capital gains on his trades of 15% per year, the fund will distribute capital gains to shareholders of 7.5% per year. For an investor with a 28% combined state and federal tax rate, capital gains taxes will reduce her returns by over 2% per year.
Mutual funds are a beautiful and elegant way to invest for the future. However, as with all investments, investors need to do their research, including a careful review of all the funds costs.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.