NEW YORK ( TheStreet) -- You stroll into a local dealership, point to the latest very-fast, very-red model and announce, "I'll take that one!" You think you've done all the research: memorized the redline, can recite its 0-to-60 time, and know the turn radius by heart.
But you have no idea what the car costs. And without bothering to ask, you plunk down a credit card, confident that the ride you'll get will be well worth anything the company chooses to charge.
No way, you say? Yet that's exactly what most of us do when we buy a mutual fund. Well-schooled in the ins and outs of investments (at least the return part of the equation!), we can read risk/reward profiles like nobody's business, and account down to the penny the amount our brokers bill for stock trades. But few of us pay attention to what we pay for our funds.
No wonder. There is little that is more confusing than the rules governing this upside-down industry. In the real world, competition means lower costs to consumers. Not here. The number of new funds is growing exponentially, but fees are up, too. Any link between pay and performance? Few and far between.The norm, instead, is that the worse you perform, the more you charge. What about a simple sticker that tells you exactly what the product costs? Uh-uh. With a jargon-packed alphabet soup of share classes, it's hard to know exactly what you will wind up paying. And even if you avoid loads and obscene expense ratios, you can still get hit with a charge AFTER you sell. Alice, welcome to Wonderland. Figuring out the price tag of your mutual fund isn't impossible, though, so let's get down to basics.
The LoadFirst, check for the most overt of the charges: a load. That's a transaction-based fee paid to an investment broker or adviser when you invest in the fund -- essentially a sales commission. As high as 8 1/2% but usually ranging from 2%-5%, loads can take a big bite out of your returns. If you set aside $10,000 to invest in a fund with a 4.5% load, $450 gets skimmed right off the top; only the remaining $9,550 goes to work for you. When you consider compounding, that really adds up. At the end of 10 years, assuming a 10% annual return, that 4.5% load costs you nearly $1200! I prefer no-load funds, but don't rule out loads. Some of the best managers in the business work for load funds. Also, depending on your investment skill and expertise, you may need an adviser's or broker's help choosing funds. Ask him or her what asset class you're buying. They range quite literally from A to Z. A shares generally carry a front-end load. B has a back-end load (you pay at the end based on how long you held the fund) with a higher expense ratio than A. C shares often have higher 12b-1 fees, but no up-front or back-end charges. Do-it-yourselfers, however, can find plenty of great funds that don't hit you with this granddaddy of mutual fund fees.
Expense RatioTrouble is that most mutual fund consumers stop with loads when it comes to expenses. We pat ourselves on the back for saving money and blithely ignore what can be an even greater drag on our investments: management and other fees. In my mind, the debate is not load or no, but high expenses or low. A hefty expense ratio can mean a lot more damage to the long-term investor than an up-front load. All funds -- both load and no-load -- have an expense ratio. It is spelled out in the expense table of the prospectus (the topic of my column next week), where you'll find what the fund charges its shareholders to run a fund (the percentage of a fund's assets deducted every fiscal year for operating expenses). The main component is the management fee, which pays for the basics of business: manager salaries, research, overhead. The expense ratio also includes 12b-1 fees (used to pay for marketing and distribution -- more on these particularly troublesome fees next week), administrative fees and other asset-based costs incurred by the fund. It does not reflect sales and redemption loads, or brokerage fees and other direct trading costs. These fees, which range from less than 0.5% to more than 3%, can be quite significant. I asked Vern Hayden, a certified financial planner at the American Planning Group, to crank out the numbers with his trusty spreadsheet. Assume you put $10,000 into three funds for ten years, and each earns 10% a year. That investment would grow to $25,426 in a fund with a 0.5% expense ratio; to $24,891 in a fund that hits you up for 1% a year; and to just $23,747 in a fund charging 2% in expenses. As you can see, you wind up with a lot less in your pocket at the end of a decade with the fund packing the higher expense ratio ($1679 less by going with Fund C rather than Fund A!).
|Fund||Exp. Ratio||Expenses Over 10 Years||You Get|
|Fund Type||Avg. Exp. Ratio|
|Growth & Income||1.29%|
|Source: Lipper Analytical Services|