The first step is to understand mutual fund expenses. The next step is to avoid them!
Mutual funds are designed for people who want to minimize risk and volatility in their investments, maximize purchasing power by pooling their resources with others, and minimize the costs inherent in buying and selling stocks. But you might be surprised that not all mutual funds have low expense ratios: many of them charge you what we feel are excessive fees. The common sense investor needs to be aware of the fees and expenses involved in any mutual fund investment.
It turns out that mutual funds that are actively traded can have surprisingly high expenses. This is reflected in their turnover costs. Actively traded mutual funds have an active manager who pays attention to the markets and will buy and sell stocks based on performance. This sounds like a great idea (we all like to know that our money managers are working for us), but actually results in increased costs.
Note: not all actively managed mutual funds have high turnover costs. Some fund managers believe in buying for the long-term and these will, subsequently, lower turnover costs.
Turnover is a measure of the volume of buying and selling that’s gone on in the mutual fund management. High turnover is something you should pay attention to in mutual funds. Make sure you always get turnover figures when you’re looking at prospective mutual funds. You’ll always see a difference in turnover between actively managed mutual funds and index-based mutual funds. For a benchmark, index funds often have fees of around .2% per year; managed funds are more likely to fall around 1.5%, a 1.3% difference. Add in the taxes, and you can see that a managed fund needs to perform significantly better to buffer the additional expense.
Low turnover in a managed fund is indicative of a long-term investment philosophy. At The Common Sense Investor, we think that the best investment philosophy is the one that sticks to the fundamentals of long-term investing. By looking for strong long-term performance but low-turnover, you can identify actively managed mutual funds that outpeform index funds. As always, stay away from funds that seem to be treating the art of investing like a game. High turn-over can be indicative of poor discipline and poor long-term vision.
Watch for this: the turnover value is sometimes divided in half because one security is sold and one bought in the same transaction. The standard measure requires both to be counted as one each. If your actively managed funds appears to have suspiciously low turnover, ask about this. Look at your management fees, too; they can be from .5% to 2.5%.
Managers who depend on commissions to make their profits are more likely to engage in high turnover management. This is usually a conflict of interests. If you find your mutual fund does this, run the other direction and get out as soon as possible!
Taxes, Taxes, Taxes
In addition to resulting in higher fees and commissions to managers, high turnover also results in higher taxes for the fund, which of course are passed on to the investor. Capital gains tax from selling an investment turns into taxable income when distributed to investors.
In today’s market, load funds should almost always be shunned and avoided.
Front-end loads are commissions a mutual fund pays to a broker when shares are purchased. Really, you should avoid loads altogether, but if you’re attracted to a load fund, watch out to be certain these aren’t too high. If you don’t pay any up-front fees, ask about how high the back-end load is; you’ll pay for it when shares are ultimately redeemed. A few funds, though, use a level-load fund, which only charges you a back-end load if shares are sold within a year. Watch out for loads; they’ve been known to be as high as 8.5%!
There are also mutual funds with no sales charges called no-load funds, and these are generally sold directly from mutual fund companies or by discount brokers for a flat transaction fee or no fee (if it’s a no-fee, it’s likely that the fund paid the broker’s commission, so check these out especially carefully.) Vanguard, T.Rowe Price and Fidelity are good no-load index fund companies.
Management and Maintenance Fees
If you have an actively managed fund, then chances are there are several employees whose full time job is to support the fund’s existence. They’ve got to be paid somehow. Normally, their salaries are usually drawn directly from the fund either as a percentage of total assets or as a percentage of total performance. Similarly, someone has to pay for office space for these employees and for other costs such as media exposure, investor relations, trading fees etc. These expenses are usually not taken from the individual investor, but get extracted from the overall fund.
If minimizing fees and expenses is your goal, than index funds are the way to go!
Index funds are mutual funds that, rather than being actively managed, are tied to a specific index, like the Dow Jones or S&P 500. These mutual funds have significantly lower expenses, but are not likely to perform quite as well. Index funds are more likely to be very general and diversified, and are good for long-term investors looking to minimize costs and volatility. The shortcoming of index funds is that they tend to not be selective between good and bad companies, and rather come close to investing blindly in a wide array of companies, some of which are good and some of which are bad.
While it is true that actively managed funds, averaged out, have historically not returned as much as index funds, we believe that you can beat the return of index funds by honing in on a no-load, low-expense, extremely well managed fund that has historically beaten the indexes by several percentage points.