Opinions and observations expressed on this blog reflect the authors' individual experiences and should not be construed to be financial advice. None of the members of this blog are licensed financial advisors. Please consult your own licensed financial advisor if you wish to act on any recommendations here.

Thursday, October 21, 2010

Mutual Fund Fees

One of the most mundane, but most important, issues when choosing a mutual fund is the issue of fees. I know very few people who can tell me what their mutual fund fees are, but they should take a good long look at them. The same holds true with ETFs, which also charge management fees.

First, let's talk about why you should care. This is because fee differentials can do murder on your long term wealth. Let's take a large cap value fund at random, say the Janus Perkins Large Cap Value Fund. It has an expense ratio, the percentage of the fund's assets it collects as fees, of 1.12%. Compare that to the Vanguard Value Index Fund, which has an expense ratio of 0.26%. The Janus fund slightly outperformed the Russell 1000 Value Index since December 2008 (13.87% vs 13.65%) and actually underperformed the Vanguard Value Index Fund over th past year by over 300 basis points. This highlights the issue that most actively managed funds cannot (I should say "will not") beat index funds. However, even if it did maintain that 0.22% outperformance over a long period, that fee differential would wreak havoc.

Let's use a ten year example where the value index does 8.00% and the Janus fund does 8.22%. At the beginning of the period you invest $10,000 and the expense ratios are assessed at the end of each year. In the case of the Janus fund you end up with $19,487 and with the Vanguard fund you end up with $21,034, a difference of over $1,500 or nearly 8%. That's even with the Janus fund's small margin of outperformance before fees. Add in the issue that actively managed funds generate more problems with pass-through capital gains and the problem compounds.

None of this is to say that there aren't good actively managed funds that can, reasonably consistently, beat the S&P 500 or any other index that they may track over time. They might not beat it every year, but over the course of several years they do. Of course, do they beat it after fees and pass-through capital gains? That's possibly another story altogether.

What this all gets at is look at the fee schedule you are paying. If the expense ratio is much over 0.70%, you are probably paying way too much unless you have a truly exceptional manager or if it is a fund that gives you exposure to some esoteric market that doesn't have a good index proxy that you can invest in. Also, very importantly, pay attention to the pass-through capital gains that are generated when the fund liquidates positions where they have made a profit. These gains get passed on to you and you have to pay, depending on the situation, either 15% or your highest marginal tax rate. One would be wise to sack fund managers who are not tax efficient.

Disclaimer: I do not own positions in any of these funds. Any advice given here is not to be taken as professional financial advice.

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