Zeroing In On Mutual Fund Expenses

John Wierenga |

As investment options continue to expand and competition for investment dollars increase, the mutual fund industry is coming under increasing scrutiny for the expenses charged in many mutual funds. With the advent of no-load mutual fund, index funds and exchange-traded funds, many investors are questioning the reasonableness of expenses charged by many of the industry’s more popular funds. In times of double-digit market gains, as have been experienced in recent years, mutual fund expenses are less of an issue, but, as market volatility increases and investors pare back their expectations, expenses, and their effect on total returns, suddenly becomes a bigger issue.

With literally thousands of mutual funds to choose from, it becomes much more important to weigh all factors when comparing fund choices. Investors have always looked at fund performance as a primary point of comparison. But, as they have learned, often the hard way, the past performance of a mutual fund is no indication of how it will perform in the future. Few funds are able to consistently outperform the stock market indexes, and fewer funds have demonstrated any capacity to repeat earlier top performances. But, there is one constant among all mutual funds that can be measured, weighed and compared, and that is expenses, specifically the fund’s expense ratio which is a measure of the fund’s operating costs. Higher operating costs will result in a reduction in the fund’s return on investment.

Mutual fund salespeople have long argued that funds with higher sales loads or expenses outperform no load or low expense funds. That is not necessarily the case. In fact, studies have shown that, collectively, index funds with lower expense ratios generate more consistent returns and outperform more expensive funds over time. This is not to suggest that you shouldn’t consider expensive funds, but it does suggest that the expense ratio is a critical factor when it comes to long-term fund performance. Although in general, index funds, which typically have much lower expenses than actively managed funds, perform much better during a bull market and actively managed funds generally perform better in a bearish market.

Understanding Expense Ratios

Investment sites such as Morningstar have done much of the work for you in breaking out the expenses and expense ratios of the thousands of mutual funds it analyzes. What’s more is they provide for easy, direct comparisons with other funds in related investment categories, so you will be comparing funds with similar objectives and management styles.

This comparison format is extremely useful for narrowing down your choices, however, there are other factors not included in the expense ratio that weigh heavily on the overall investment cost and long-term performance of the fund. For instance, the portfolio turnover rate – the rate at which the investment managers buy and sell stocks – can increase the investment costs if the rate is high. When stocks are sold frequently to capture short term gains, the portfolio is taxed on the gains and that cost is passed on to you in the form of reduced returns.

Additionally, the expense ratios don’t reflect other costs such as fund redemption fees or sales charges. Not all funds include these charges, but where they exist, they are paid directly by the investor so they aren’t included in the expense ratios.

Load vs. No-Load

With so many fund choices, investors may not have to consider funds that charge sales loads (commissions) or 12b-1 fees (annual sales fee). But, it’s not always wise to step over a dollar just to save a dime. While no-load funds may seem like the better choice, it’s important to carefully examine the investment management fees. Some fund companies will try to make their funds more attractive by eliminating the sales load, but then they will recoup the lost revenue by increasing other fees. Just a half-point increase in the annual management fee could extend the expense break-even point of the fund out several years.

A load fund with very low management fees or expense ratio, could very well achieve a break-even point much sooner. The problem is that the fund analysis available through sites like Morningstar doesn't factor in sales loads, so you may have to calculate the true break-even point on your own. It is also important to note that many load funds enable IRA investors to buy shares typically available only to institutional investors. These shares can often times be purchased without a sales load and with lower minimum investment requirements. As a Fee only RIA firm held to the “Fiduciary Standard”, all funds Pilgrims Capital Advisors, Inc. purchases for our clients are no-load or an institutional class of share with lowest management fee available and without sales charges.

Expenses are Only a Part of the Story

Expense ratios should always be considered when selecting mutual funds for your long-term investment portfolio. But, it’s important not to ignore other key factors that will help you determine how closely a mutual fund actually matches your investment profile including your tolerance for risk. Measures such as the Sharpe Ratio or the Alpha Ratio are key indicators of a fund’s relative volatility and its risk versus the stock indexes, which, in the long run, can be far more important than the expense ratio.

These weekly articles which are produced and distributed by Pilgrims Capital Advisors, Inc. contain information on topics about investing, tax planning, estate planning, asset allocation, insurance and many other financial subjects. Please note that they are very general in nature and must be applied to your own individual circumstances through the services of a trained or licensed professional that specializes in these areas. If you have questions or needs related to the subject matter of this article please contact us by clicking on the link below and we will point you in the right direction.

Pilgrims Capital Advisors, Inc. is a Registered Investment Advisory Firm located in the state of Michigan.