Question Of The Month June 2010

How High Are Your Mutual Fund Fees?

Do you pay 1 or 2 percent in annual mutual fund fees?  Or is it 5, 10, 15 percent or more?  Do you know what you pay to invest in your mutual fund?  Are they too high?  And for us --- the planning, saving and investing for retirement people, the percentage that we pay has an impact on our nest egg.

Ian Salisbury, in his Wall Street Journal column Fund Track, allows us to take a look at this debate from a number of perspectives.  “Maybe you really shouldn’t know because if you did, you wouldn’t like the results.” 

An investing web site---kaChing ----says that it is 3.3% of assets per year for stock funds.  However, The Investment Company Institute, the fund industry’s trade organization says that the charge is less----1.17% per year.  KaChing, says prevailing estimates fail to quantify factors like trading commissions and taxes, which it plugs in to get its figure for the average annual costs of actively managed stock funds.  

KaChing's 3.37% is more than triple the 1% many analysts use as a rule of thumb to denote high-cost funds.  "Mutual funds are promoted as having very low management fees," says kaChing's chief executive, Andy Rachleff. But those costs "are just the tip of the iceberg."

For us --- planning, saving and investing for retirement people, the stakes in the fees debate are large.  When you compound over a couple of decades, the small differences in costs are compounded over decades and that can amount to tens of thousands of dollars.

The fees debate has attracted the attention of the U.S. Supreme Court.  They are reviewing a case alleging that mutual-fund companies take advantage of the complexity of calculating mutual-fund costs to overcharge investors.  The NPR Blog notes that the Court is unhappy that Oakmark family of mutual funds charges individuals twice what it does institutions like insurance companies and pensions funds. 

As part of the case, supporters of the industry's position use the ICI's cost estimates to argue that mutual-fund expenses have fallen since the 1980s.

When you look at the two positions, the biggest difference between the kaChing approach to mutual-fund costs and the ICI's is investors' tax liability. To kaChing, taxes add an extra 0.94 percentage point to fund costs.

An often-criticized aspect of mutual funds is that investors can get saddled with capital-gains taxes, even in years when they don't buy or sell fund shares. That is because mutual-fund investors must pay their share of the capital gains that funds accumulate through their own trading activity. This can leave investors on the hook for trading profits earned by a fund even in the years before they became fund owners.

How the court will rule is this case is not known but the case highlights the conflict of interest that has long plagued much of the fund industry. Most funds have a financial incentive to charge the highest fees they can, since that's how they make their money. But at the same time they have a fiduciary responsibility to put us planning, saving and investing for retirement people interests first.

It looks very different if you see fees as a percentage of investment returns, which is a much more appropriate view. Invest $100 in a fund with assets that gain 10 percent and that 1.5 percent fee chews up 15 percent of your profits. If the fund gains only 5 percent, the fee comes to 30 percent of profits.

When you see fees as a portion of returns rather than assets, it's easy to understand the daunting challenge that fund managers face. If the index fund returns 7 percent, the investor ends up with 6.8 percent after paying fees of 0.2 percent. To match that after-fee result, the managed fund must select holdings returning 8.3 percent. That means its return has to be nearly 19 percent better -- 8.3 vs. 7.  But, will your mutual fund sales person tell you that? 

Probably not and that is why us  planning, saving and investing for retirement people need to know and do all that we can to keep our costs and fees as low as possible. 

 

 

Expensive Fund: 8% annual return, 1.2% annual expense ratio Year Beginning balance Ending balance 1 $10,000 $10,670 10 $17,932 $19,134 20 $34,311 $36,611 30 $65,651 $70,052 40 $125,617 $134,038 50 $240,356 $256,469 Cheap Fund: 8% annual return, no expenses Year Beginning balance Ending balance 1 $10,000 $10,800 10 $19,990 $21,589 20 $43,157 $46,610 30 $93,173 $100,627 40 $201,153 $217,245 50 $434,274 $469,016 40 $201,153 $217,245 50 $434,274 $469,016