About the High Cost of Mutual Funds
. . . And What You Can Do About It
Most People and Mutual Funds Do Worse Than Average
It is maddeningly difficult to "beat the market." Indeed, most people
and most mutual funds actually do worse than the market averages each
year, for a very simple reason: the averages are just that theoretical,
numerical averages. They pay no brokerage commissions, they pay no fees, they
pay no taxes.
What Counts Is How Well You Do After Costs
If the stocks in your mutual fund were up 10% some year, that's fine
but how much were you up? There are fees. There are transaction costs.
And outside a tax-sheltered retirement plan, there are taxes. As you can see
from playing with our calculator, in some cases that 10% could be cut to 7%
A Little Difference Becomes a Very Big Difference
You may think, "Well, 7% isn't 10% but at least it's 70% as much.
I'm only giving up 30% of what I could have had if there were no costs."
The funny thing is that, the way compounding works, that's not true.
Take $10,000. Yes, the first year it grows by $700 if it's growing at 7%, versus
$1,000 if it's growing at 10%. So the first year, you get to keep 70% of the
potential gain, giving up only 30% to costs. But look what happens with compounding.
After 40 years, your $10,000 will have grown to $149,000 at 7%; but to $452,000
at the full 10%. You are leaving $303,000 on the table! That's not a
mere 30% of the $442,000 gain you could have had it's 68%. That
makes you, in effect, just a 32% partner in your own success.
Over a lifetime, even 1% makes a huge difference. If you put away $2,000 a
year for 50 years at 8%, you'd have nearly $1.25 million at the end.
Not bad. Doing just 1% better, though, you'd come out more than half a million
dollars ahead just north of $1.75 million.
Focus on Costs . . .
Here's our message: In trying to decide which among thousands of mutual funds
to buy, or whether to keep one you already own, ignore last year's sizzling
performance and the "star" ratings and the magazine covers that scream
"The 10 Best Funds to buy NOW!" Look past the marketing hype
and focus on the costs. This is the most important thing to do
and what most people fail to do.
. . . Because Predicting Costs Is Much Easier than Predicting Performance
of research have shown that superior past performance generally
does not "persist," but that inferior past performance, when
caused by high costs and taxes, generally does.
The truth is that good funds have bad years and bad funds have good years,
and nobody can predict which funds will be the best stock-pickers in
the future. Listen to Mark Carhart ("On Persistence in Mutual Fund Performance,"
Journal of Finance March 1997), who now co-heads the quantitative
research group at Goldman Sachs:
"While the popular press will no doubt continue to glamorize the best-performing
mutual fund managers, the mundane explanations of strategy and investment
costs account for almost all of the important predictability in mutual fund
In short, the familiar disclaimer that "Past performance cannot guarantee
future results" should really read, "Past performance is largely
useless in predicting future results." Except when it comes to
What Are the Costs and Why Do They Matter?
There are four basic kinds of costs associated with owning mutual funds:
These are paid to the company that manages the investment portfolio
These are paid to the broker or adviser that sells the fund and services
the account. In some cases, it's a straight up-front sales commission
("load") or a surrender fee you pay when you sell the fund. But other
funds "no-loads" may charge an annual "12b-1 fee."
It seems small compared with a sales commission except that it nicks
you year after year after year. (In still other cases, the fund manager simply
uses part of its management fee to pay for marketing and distribution. You thought
that hefty fee was going to a team of brilliant analysts, but some of it was
going to pay brokers or buy ads.)
These are incurred by the fund as it buys and sells securities. Trading costs
money, and it comes out of your money. There are brokerage commissions,
of course. (And they are not always rock bottom. Sometimes, to keep its reported
management fee low, a fund will pay for investment research with what are called
"soft dollars" higher commissions than they might otherwise
have to pay.) Beyond commissions, there are spreads. With a Picasso, a gallery
that would sell it to you for ten million might buy it from you for only five.
With 10,000 shares of a stock, the spread between "bid and ask" prices
will be much smaller but meaningful nonetheless. And there's another
aspect to this. If you or I want to trade 500 shares of stock, it rarely "moves
the market." What we add to the supply (if we're selling) or demand (if
we're buying) is insignificant. But what if, like a mutual fund, we were trying
to buy or sell 200,000 shares let alone in a hurry? We might sell the
first 5,000 shares at 50, but have to accept as little as 49 or 48, on average,
to move them all. Buying, we might find that our demand for these shares had
bid their price up to 51 or 52 by the time we had gotten them all.
Mutual fund managers are generally sensitive to this, of course, and attempt
to trade cheaply and wisely. But the same Mark Carhart quoted above found that,
on average, a fund with 100% annual turnover gives up nearly 1% in transaction
costs. A fund with 25% turnover would give up only a quarter as much. A fund
with 300% turnover three times as much.
Transaction costs are not incorporated in a fund's "total expense ratio."
They are taken directly out of shareholder assets.
The fund itself does not pay taxes. Shareholders who own the fund in
taxable accounts pay taxes on dividends and capital gains distributed by the
fund. And there's reason to think that many fund managers don't worry too much
about this. Indeed, because they know shareholders feel good when they get distributions,
some will actually realize gains unnecessarily, just to have something to distribute.
This may be good marketing, but it's bad financial strategy.
But Don't You "Get What You Pay For?"
It would be different if the funds that charged the highest fees could justify
them by turning in the best performance. Who wouldn't be willing to pay
1% or 2% a year more for a fund that could beat the market by 5% or 10% a year?
In practice, there's no evidence that higher-cost mutual funds earn higher
returns than their competition. Quite the contrary.
Yes, some funds excelled last year. But counterintuitive though it is
this tells you little or nothing about how well they will do next
In high school, as I have written elsewhere, you can be pretty sure an A-student
this year will get good grades next year, also. Not always, but generally. In
mutual funds, this is not the case. The market is fluid. A portfolio manager
may ride a wave for several years with his particular investment style, only
to capsize when things change. Or he may grow lazy or distracted (an affair
of the heart? that new house on the fairway?) or move to another fund.
Even if you know he's gone, it's not practical to sell your shares and follow
him with your money if, in so doing, you'd incur taxes or a new sales load.
The market is so competitive, with so many bright people (and not a few dumb
people) canceling out each others' views, it is very hard to beat the averages
even by 1% or 2% a year. Few do. And once you subtract the extra fees and costs
an actively managed mutual fund will often incur let alone any up-front
sales commission it just becomes so hard to win this way. Might
there be a few lucky souls who do? Definitely. But the much easier way to assure
reasonable investing success, relative to your friends and neighbors, is to
focus on costs.
How Much Can I Realistically Expect to Earn?
In these years of 20% and 30% gains in the market . . . of companies going
public at $18 and closing their first day's trading at $93 . . . it's important
to realize that the true long-term rate of return on U.S. stocks, after
tax and inflation, has historically been only 3% - 5% per year.
I tell you this not to depress you, or even to help you make more realistic
retirement-planning assumptions, but to bring into still higher relief the relative
importance of an extra 1% or 2% in costs.
(The average historical total rate of return on the Standard & Poor's 500
from 1962 to 1997 was about 11.5%. But that would not have grown $20,000
into $1 million, as your pocket calculator suggests. After taxes and inflation,
you'd have had about $80,000 in 1962 purchasing power. A lot better than
nothing, and a lot better than the results from a savings account or government
bonds. But a true rate of return of about 4%.)
It's not as much fun, but for most people the wisest strategy is not to try
to guess tomorrow's hot stock or fund, but to keep for themselves as much of
the market's return as they can, and to pay as little as they can in costs.
The Appeal of Passive Investing
It is for precisely this reason that many smart people today don't try
to beat the market. They merely try to match it, or close to it, by buying and
holding a broad cross-section of stocks. This strategy is called passive investing,
and it outperforms most actively managed mutual funds especially in taxable
Ironically, most people who try to "beat the market" end up with
mediocre results, while those who merely try to match it outshine the average
One way to invest passively is with index funds that track a large set of stocks,
such as the S&P 500 or the Wilshire 5000. This is so easy to do that it
can be done at very low cost. (Some index funds nonetheless charge much more
than others check out any fund with our calculator before plunging in.)
And because index funds basically just buy and hold they don't wriggle
around buying and selling in an attempt to beat the market they generate
little or nothing in the way of taxable capital gains until, years from now,
you sell and take your profit. In the meantime, you have Uncle Sam's share of
your money working for you, too.
Spiders and Diamonds
Another way to invest passively is with securities that trade on the American
Stock Exchange just like stocks. "Spiders," as they're affectionately
known, mimic the S&P 500 and trade with the symbol SPY. "Diamonds"
DIA mimic the Dow Jones. And there are other cousins as
well that attempt to represent a broad range of mid-sized companies and
of foreign markets. Some argue that these securities are even better than
the cheapest index funds. I've always felt that for most individual investors
it doesn't make much difference.
And if you're concerned the world would end if "everyone"
indexed, click here.
The Ultimate Low-Cost Fund
Still another way to invest passively is to "do it yourself." Namely,
to buy and hold a diversified portfolio of individual stocks and, in effect,
build your own "personal fund" a concept only recently made
practical by the Internet.
Over the months to come, Personal Fund, Inc. will provide investors the information
and tools to match, or nearly match, "the market" not only
saving dramatically on mutual fund fees in some cases, but also, for investors
in taxable accounts, allowing them to control the tax consequences.
But our first step is to illustrate to mutual fund investors just how much
potential gain they are giving up today hence the Mutual Funds Cost Calculator.
Indeed, we hope this Cost Calculator will continue to prove useful long after
thousands of investors have begun building their own personal funds.
Register with us and join us on this interesting
journey. Registration is completely free.
Click here to find out how much your funds