Wednesday, July 2, 2014

The Hidden Cost Of Mutual Funds

I want to talk a bit today about a little noticed figure in mutual fund reports that most people don't pay attention to but that can affect your return in a large way, especially over time. That figure is what is known as the Expense Ratio and it comes in two varieties - the Gross Expense Ratio and the Net Expense Ratio.

There are many ways to own mutual funds, but probably the way most Americans own shares is through their 401(k) or 403(b) retirement plans offered by their employer. These plans usually offer a limited number of mutual fund choices to invest in and you as an investor are stuck choosing from those options offered to you. The choices may or may not be to your liking, but given that investing in a retirement plan is more or less a requirement in order to have some semblance of financial security in your elder years, you might as well try to pick the best of what may be a bad lot.

When comparing mutual funds, many people look at the funds' past returns, although, as the legal warning goes, past performance is no guarantee of future results. Companies like Morningstar and Lipper also offer mutual fund ratings and analysis services. By now, almost everyone knows that fees of any sort are bad. As such, most mutual funds have eliminated them and are technically "no fee" funds. Here's an example of some of the funds offered by my company's 401(k):

No fees sounds awesome! There must not be any costs to me if I invest in these funds! Whoa there, Tex. Not so fast. If we scroll over further in that chart, we come to the last column:

These funds may not charge fees, but they do have expenses. Mutual funds are required by law to disclose the gross expense ratio to you. There is another expense ratio, the net expense ratio, that they are not required to disclose. Of course, the one that is not required to be disclosed has a more direct impact on you.

What's The Difference?

From the Motley Fool Wikipedia: "The gross expense ratio of a mutual fund represents the cost of running a fund as compared to the profit earned by the fund. Gross expense ratio figures consider all of the expenses of a fund, including administrative and accounting costs and fees associated with investments made by the fund."

Net expense ratio is "the gross expense ratio of a mutual fund minus acquired fee funds and any fee waivers or expense reimbursements made to investors by the fund. Acquired fund fees constitute the costs, such as the expense ratio, of mutual funds or similar securities and commodities in which your mutual fund invests."

So the net expense ratio is typically less than the gross expense ratio because many mutual fund companies waive or reimburse the fund for some of their expenses in order to keep the expense ratio low. This is because funds with high expense ratios won't attract many investors. If you look at reports on mutual funds, you'll often see these figures reported. For example, here's a section from a mutual fund report by Lipper:

You can see that the net expense ratio is less than the gross expense ratio. This tells you that the mutual fund company is waiving some of their fees. In fact, you can see they have a contractual expense waiver in place until 3/31/15, when it expires. It may or may not be renewed. We don't know. So, potentially,on April 1, 2015, investors in this fund may suddenly start being charged more.

Now compare this to a mutual fund that mimics the S&P 500:

Index funds, or mutual funds that seek to mimic a particular index, in this case, the S&P 500, are typically cheaper than actively managed funds. This is because there's no research involved. The fund just buys stocks that make up whatever index it is emulating in the same percentage they occur in the index. You can see the expense ratio is almost a full percentage point less than the earlier actively managed fund. There is no 12b-1 fee, which is a fee charged by the fund to advertise the fund and to pay commissions to brokers who sell shares of the fund.

So What Does This Mean To Me?

You pay the expenses for a fund when you invest in it. If you have Fund A that has a 5% return and a 1% net expense ratio, your return on the fund is 4%, because the fund takes 1% for operating costs. Note that these operating costs are charged even if the fund loses money. If Fund A dropped 5% last year, your investment actually dropped 6% because the fund still took it's cut for expenses.

You can clearly see there is a direct connection between the expenses of a fund and your return. If you are not careful and only look at a fund's return figure, you're not getting the whole story. In reviewing the funds offered by my company's 401(k), I found the expense ratios ranged from a low of 0.50 percent to a high of 1.7%. That's a 1.2% difference. Not that much, you say? You're forgetting about the value of compounding over time.

Let's look at a $50,000 investment in two funds over a period of 25 years. One fund returns 5% and after 25 years in that fund, that investment would be worth $169,318. Another fund returns 3.8%, or 1.2% less than the first fund. After 25 years, that investment is worth $127,029. That extra 1.2% that you don't pay in expenses add up to an extra $42,289. To put it another way, you'd get an additional 84% of your original investment amount by choosing the lower cost fund!

It's worth your while to take a look at your current 401(k) or 403(b) investment options now and see what sort of expense ratios you may be paying.

By the way, there is an awesome mutual fund comparison tool at the Financial Industry Regulatory Authority's website at Select up to three mutual funds, an investment amount, return rate, and time frame and the site will show you the difference in costs and values of the funds.


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