Mutual Fund Expenses- Back to Basics
Jack Bogle is perhaps the biggest critic of the mutual fund industry, which is somewhat ironic in that he is the founder of its biggest firm, Vanguard. He criticizes the industry for giving investors what they think they want (such as 3X Bear Funds or Russian Tea Kettle Stock ETFs ) instead of what they need (broadly diversified index funds). But most of his criticism is directed at the (generally excessive) costs of the mutual fund industry. Part of the reason for the success of Vanguard is that they have dramatically reduced and/or eliminated most of these costs, allowing the investor to keep the difference. As previously discussed in my post on diversification, mutual funds provide a great service to an investor by essentially eliminating individual security risk. But it is important not to pay too much for that benefit, especially now that stock trading commissions are so low ($0-10 per trade) compared to a couple decades ago.
Expense Ratio (the other ER)
This is the cost of running the fund. It pays the salaries of the employees, it pays the commissions to buy and sell securities, it pays compliance costs, it pays to send out annual reports, it pays for the paperwork and communication with you, and for an actively managed fund, it pays for research. It is usually expressed as a percentage of the assets in the fund. For example, if the expense ratio (ER) is 0.5% for a mutual fund with $100 Million in it, the cost of running that fund is $500K per year. I have seen these ratios from as low as 0.02% (the federal TSP funds) to as high as 4.39%. Average ratios for stocks are just over 1% and average ratios for bonds are just under 1%. A general rule is that you shouldn’t pay more than 0.25% for broad based index funds, no more than 1% for actively managed stock index funds, and no more than 0.5% for actively managed bond funds. Funds that invest in smaller stocks or smaller countries generally have higher expense ratios. The less you pay, the better.
There are load mutual funds and there are no-load mutual funds. I suggest you only invest in no-load mutual funds such as those offered by Vanguard. However, if you’re like most doctors (including myself) at some point you have bought a loaded mutual fund. How can you tell? The easiest way is to go to Morningstar.com and put the ticker symbol into its “quote” box. Then click on the expense tab. Then go down to sales fees. If there is a “-” in the box, congratulations, the fund is no-load. If not, well, don’t make that mistake again. There are different “classes” of most loaded mutual funds.
Class A- These are the classic “front-load” share. A load is a commission to pay the guy selling you the fund. If the load is 5%, and you invest $1000, $950 goes into the mutual fund and $50 goes to your “financial advisor.” You start your investment $50 in the hole.
Class B- These shares have a “contingent deferred sales charge”, or a back load. You pay the same commission to the salesman, but it is hidden from you. You pay a higher expense ratio (normal ER plus part of the commission) for a few years until the shares turn into Class A shares. If you sell before they convert, you’ll pay the rest of the commission at the time of sale.
Class C- These shares are even trickier. I once bought these thinking I was getting a no-load fund. Basically you pay a higher expense ratio indefinitely but the shares never convert to A shares. The good news is if you get out fast, like I did, you won’t end up paying much commission (there’s no back load on these.) The bad news is that if you never get out, you’ll end up spending more in the long run than the guys who bought the A shares and paid the load up front.
Class I- These are institutional shares, require a very high minimum investment (like $1 Million), but don’t have a load.
Class R- These are shares used in retirement plans such as 401Ks. A lot of times the load is reduced or even eliminated for these investors. (Don’t worry, they’ll nail you with ridiculous 401K fees to make up for it.)
Basically, you don’t want to buy any mutual fund that has A, B, or C shares. Different companies have lots of different types of shares, so be careful. There’s an article on Investopedia that is supposed to help you decide which class to use. What it never mentions, however, is the fourth option- no-load funds. You won’t get told about these by your commissioned financial advisor though. Keep in mind that even no-load mutual funds can have different classes. For example, with Vanguard Total Stock Market Index you have Investor shares ($3K minimum, 0.18% ER), Admiral shares ($10K minimum, 0.07% ER), ETF shares (no minimum but must pay commission, 0.07% ER), Signal shares ($5 Million minimum, 0.06% ER), Institutional Shares ($100 Million minimum, 0.045% ER), and Institutional Plus Shares ($200 Million minimum, 0.025% ER). Other mutual fund companies such as Fidelity give similar breaks for large investments. Loaded mutual fund companies tend to give you a break on the load if you invest a lot in the fund, but why pay any load when there are so many good no-load funds out there?
Some mutual fund companies (notably Vanguard) charge fees when you buy into or sell out of mutual funds that are particularly expensive to administer. These generally include new funds, emerging market funds, and small stock funds. Sometimes sell fees go away if you hold a fund for a period of time, ranging from 30 days to 5 years. These fees tend to be much lower than loads (usually 0.25-2%) and instead of the money going to an advisor, it goes into the fund. So the longer you’re in the fund, the more of these fees you collect from people who are jumping in and out of the fund. They are usually designed to promote buy-and-hold behavior, which is probably a good thing. Advisors like to think loads do the same thing. Uhhhh…..yeah. Amazing what some people can justify. Vanguard’s buy/sell fees can be avoided completely by purchasing the ETF version instead of the mutual fund version of the fund.
As if it wasn’t enough to have to pay the guy selling you the overpriced fund to begin with, you also have the pay the advertising and marketing costs for the fund. These are often an additional 0.25% a year. Don’t buy funds that charge a 12b-1 fee. Period. Just like loads. No loads. No 12b-1 fees.
Invisible Fees (AKA transaction costs)
Large mutual funds, and hyperactive mutual funds incur significant amounts of other costs that are important to be aware of. When considering a fund, it is a good idea to look at the turnover ratio. This is the amount of its holdings that it buys and sells during the year. If 20% of the shares in the fund are sold in any given year, then the turnover ratio is 20%. These ratios can range from ~4% to 400%. The higher the turnover ratio, the more the fund has to pay out in commissions and spreads. Just because you don’t have these reported to you directly, doesn’t mean the fund isn’t paying them on your behalf. They certainly aren’t paying for this stuff out of the ER. The commission is what the fund pays to buy or sell a security. The spread is the “market-makers” take. Remember when you buy a stock, there is a bid and an ask price. You can only buy at the ask, and you can only sell at the (lower) bid. The difference between the two is the spread, or the amount the market-maker makes. With frequently traded securities this amount is quite low, but with a thinly traded security, watch out! It could be 1-5%! It’s even worse with non-publicly traded securities (or timeshares). The spread could be 10-20%! Large mutual funds also suffer from impact costs. Basically, when a mutual fund manager wants to buy a whole bunch of shares of a new stock, he gets a pretty good price on the first few shares he buys. But then, as the market starts realizing that someone is buying, the price goes up a little, then a little more. The actual act of buying the security raises the price. The bigger the fund (and thus the purchase) the bigger the impact cost. It works in reverse when selling. The more you sell, the lower the price gets. You can minimize these fees by using index and other very low turnover mutual funds.
Many mutual fund companies charge an annual accounting fee, paperwork fees etc. Sometimes you can avoid these by investing a certain amount or taking your statements electronically.
Remember in investing you get what you don’t pay for. It is important to use mutual funds to simplify your investing life and to get solid diversification at a low price, but don’t give away the farm to get it by paying unnecessary loads and fees or ridiculous expense ratios. When choosing funds from your 401K selection, you’re usually better off selecting from those with the lowest expense ratios. Past performance doesn’t predict future performance, but low fees do predict not only future low fees, but future good performance.