Apr

3

Drags on Your Portfolio Returns

Company BannerThe following is an article from my Weekly email.

As the New Year gets underway, you might be considering investing in an actively managed mutual fund. Most investors evaluate the cost of owning a mutual fund by looking at its expense ratio. However, there are four “hidden” mutual fund fees that are not captured in the expense ratio of which you should be aware. All costs, whether published or hidden, will  act as a drag on your ability to grow your nest egg. Below are some guidelines to help you better understand these hidden costs.

Transaction costs – Mutual funds and exchange traded funds (ETFs) are regularly buying and selling shares of companies that the funds own. And just like you have to pay a fee to buy or sell a share, so do mutual funds. Of course, they are buying on a much larger scale than you are. That helps them keep their costs lower on a per share or per transaction basis. Even with economies of scale, transaction costs really add up. And they are not factored into the expense ratio. Many experts put the average fund transaction cost at 0.5%.

Cash assets – Actively managed funds often keep a fair amount of the money invested in cash to cover redemptions and other expenses. Actively managed funds keep, on average, about 5% of their assets in cash. How does that affect your returns? There is a premium for equity over and above cash. In other words, you expect the return on equities over a long time period to exceed the return on cash. If a fund has 5% in cash, over the long term, it is going to cost you about 0.3% in lower returns.

Sales load – There are really two different kinds of sales loads. The first is loaded funds, where you have to pay a 5% fee to buy into the funds. The 5% sales charge goes to the brokers, who get commissions for selling you the funds. The percentage of funds that charge loads today is lower than it used to be. The sales charges are lower, too. Today, they’re typically around 5%.

Tax efficiency – Actively managed funds, by and large, are less tax efficient than index funds. If your money is in a 401(k) or an IRA, that does not matter. However, if you have money in taxable accounts, it can be important. Actively managed funds buy and sell shares more frequently than do index funds. These transactions occur for various reasons, primarily the result of the fund’s manager moving in and out of stocks in an attempt to maximize returns. This turnover makes actively managed funds less tax efficient than index funds. You can use MorningStar to see a fund’s pre-tax return and the tax-adjusted return. MorningStar actually calculates a tax-cost ratio for each mutual fund to give you a sense of how bad the tax hit will be for that mutual fund based on many factors; primarily capital gains because of the constant buying and selling.

Understand the long term cost to your wealth – Assume a 1.12% expense ratio for the average actively managed mutual fund. Add to that all the hidden fees discussed above, and it adds up to 2.27%. On the surface, 2.27% does not seem like that big a deal. But let us assume that stocks return 7%, a modest assumption based on historical data. If you lose 2.27% in an actively managed fund to all these fees, it will consume 33% of your total return over a lifetime of investing. This is the magic (or horror) of compounding. With these fees, you are losing 2.27% every year, but you are also losing the interest or growth you would have enjoyed had you not lost the 2.27% to begin with. In one year or even five years, that may not be a big deal. But in 10 years, it starts to hurt. In 20 to 30 years, as this problem builds up, it has more and more impact. And, you end up losing almost 33% of your returns.

Citations
1. http://bit.ly/1tWtgKv – Fidelity.com
2. http://onforb.es/1BTTJa3 – Forbes
3. http://cfa.is/1xQb2tn – CFA Institute
4. http://bit.ly/1xQb6cA – DoughRoller.com
5. http://to.pbs.org/1xafL4b – PBS Frontline

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Category: Article, Blogs

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