Keeping an eyes on costs of mutual funds
If you ask a woman how much does that LV bag costs, chances are she can most probably tell how much it cost within a dollar margin. However, if you ask her how much she pays “talented people” for professional money management, there is also a good chance that she got no ideas. There exists the same probability that she is paying much more for money management than for her LV bag. If there is a financial adviser managing her wealth, the fees will be around $3000 to $5000, coupled together with 1% fee for a $100 000 portfolios, which is another $1000 per year and 1% is a conservative estimate for active managed mutual funds.
Professional wealth management is really a great business to be in, just look at the number of financial advisers on the streets, gathering contact numbers for financial consultations. Investors tend to be less aware of the relatively large figure spent in asking someone to manage your money. The reasons are not hard to understand, there is no bill or receipts showing how much you owe for managing money, fees are even out during the year and investors’ tendency to focus on returns since at any given year, there is a good chance that the returns are either significant larger or smaller than the costs of management. However, please know that these fees being not small in the first place, will add up to quite a lot decades later, given the compounding effect.
There are costs in managing a fund, be it active or passively managed, these costs are, including but not limited to, management fees, administrative expenses, marketing and distribution costs. A particular fund’s expense ratio basically tells you the percentage of a fund’s assets that is used to cover all the various costs as listed out above. A $10 million dollars mutual fund with 1% expense ratio means that it is charging all the shareholders of that fund $100 000 each year to manage their money.
1. Considering expense ratios
If all the fund’s expense ratios are the same, then there is no need to think much about this point. The fact is that not all the fund’s expense ratio are the same, or not all higher expense ratio translate into equally high quality management. Do take note that the highest expense ratio in the world does not have the best fund managers; neither do the lowest expense ratio has the lousiest fund manager.
Most investors tend to look at the charts showing all the wonderful past returns and assumed that since the fund can achieve great returns and more than enough cover its higher expense ratio, there is no reason or at least a good chance that it will be able to in the foreseeable future. This is a reasoning fallacy that you should overcome if you were to attain greater wealth, as the rationale behind is simple to understand. The statistics is that for every high cost fund, together with higher risk, that managed to make great returns, there are at least ten more others who fail. But those who fail get sweep under the carpet, television and other forms of mass media rarely give coverage to losers. This is like you always hear success stories of Bill Gates but there are many others who fail in businesses and never to succeed in making millions throughout their life and that only lottery winners receive press coverage, but not the millions who win nothing. Funds that kept losing most probably close down already, where got let you see the past returns and feels impressed by its track record.
In general, expense ratio seldom if ever changes with time passes, as a result, they are one sure indicator of future returns since with the effect of compound interest, a fund with much lower expense ratio generates much greater return for the same annualized return over more than 20 years period. The difference between a cheap and not so cheap fund does not add up to a few dollars for a cup of Starbucks coffee after more than 20 years, the difference can be a few thousands or more, depending on your investment capital. This is not a hypothetical situation; in fact, this is what happens in practice also. A study performed by Morningstar shows that for all categories of mutual funds, funds with lower expense ratios already outperformed those with high costs over a five years period already.
There is an implicit assumption that if you want higher quality, you have to pay more. A belief that most people, including myself holds for other things in life, but this is not the case in the universe of mutual funds. The probability that an outstanding individual runs a low cost fund is actually around the same as a fuck out manager running a much more expensive fund. Anyway, there are many examples in other aspects that paying more does not translate into higher quality, one does not have to look far from at Windows and Linux or even the government of a small city state.
Always check the expense ratio of the funds you intend to buy or already own, if there are some that are more expensive than what is the norms for their respective categories, see and check whether you can switch to a lower annual fees alternative.
2. Knowing the market rate for expense ratios
By right, economically and theoretically speaking, one should not pay more than is necessary for a given mutual fund type. In general, the lower the expected return of a particular asset class, the lower one should fork out in expense ratio or annual fees. This is not hard to see, fund managers know that it is not easy to beat other fund managers when it comes to bonds and the fact that it really does not take much time and effort to select triple A bonds with the required maturities. As trading of bonds is mostly done by institutional investors, and institutional investors are people with first class honors degree from Harvard or MIT (the institutions is staffed by people with that qualifications), it is easy to see that why there are relatively few opportunities to achieve returns by a big margin than other fellow fund managers. As a result, for a bond mutual fund, there is a very good chance that funds with much higher annual fees do worse than those with lower annual fees.
In general, you should not invest in a bond fund with expense ratio higher than 1%, as the total return is likely to be in the area of 5% return. If the fund cost more than 1%, you can see that the return can go very low, coupled with the fact that it is unlikely the fund manager can do much work to justify the higher than 1% fees, even for bond funds targeting emerging economies.
3 Keep a lid on sales charge
For those uninformed, sales charge is the upfront cost when buying a mutual fund, though there are other cost structures associated with mutual funds. Let us look at the following distinct cost structures of mutual funds and some advices on which are suitable in which circumstances.
a. No-load funds
No-load funds are simply those that carry zero sales charge, meaning to say that there are no fees levied when buying and selling. This is suitable for those who can build an outstanding portfolio in a one man show, all by yourself. But there are people who are not very familiar with asset allocation and the time to constantly monitor portfolio, especially if you are an A list celebrities like Tom Cruise, top surgeons or lawyers with obscene income. In this case, paying for a good financial adviser or broker and spending on sales charge will be better and wiser.
b. Front-end load funds
The name already tells us that for this type of funds, sales charge is simply the upfront cost. That means if you invest $1000 and the load is 5%, you will ended up paying $50 in sales charge and investing $950 into the fund only. This type of cost structure is suitable for long term investors who purchase through a financial adviser or broker, if and only of the annual expenses is low enough to justify the higher upfront commissions.
c. Deferred load funds
The name also tells you that there is no sales charge at the time when the fund is bought but of course the sales charges is still going to be charged on you, later when you sell the fund. In addition, the sales charge decrease each year that you holds on to the fund. But this is only one side of the equation, there is still another side which is its annual expense, deferred load funds usually include high annual fees commonly known as 12b-I fees which contribute to the fund’s expense ratio. The high priests of finance like brokers like to sell this type of mutual funds and kept emphasizing on its favorable sales charge structure because they receive income every year from this 12b-I fees but these high annual fees can drastically reduce returns even though the sales charges deal sounds like a good deal. In general, front-end load funds have lower 12b-I fees and hence lower annual fees.
d. Level load funds
They have either zero or relatively low sales charges and a level 1% annual fees which may be high for a particular fund. They are more suitable for a very short term investor and definitely not good for a long term investor. With totally no sales charges, a short term investor can buy and sell in short time period in a volatile market and make quick buck.
Last but not least, for every load fund, there will be a no-load alternative.
4. Be aware of hidden costs
Other than obvious and stated costs like sales charge and annual fees which is the expense ratio, there are two types of hidden costs that can be a large drag on bottom lines. These two types of hidden costs will of course eat into your return, though they are not included inside expense ratio in the first place.
a. Market Impacting Costs
There is a difference between fund managers selling large blocks of share and small files like you and I selling a few lots of shares from time to time. For a large block of shares that belong to a single company, selling it in a matter of few days’ means that there is a high chance that the selling price is less advantageous with each lot being sold, the reason being that of simple supply and demand. At any one time, only a finite number of people will want to buy the stocks of a company at a certain price. If there is an increased supply of shares, offer prices have to drop before other the same or other buyers will want to buy as they also have finite money for purchasing them. In other words, if only around 1 million shares of a stock changes hand on a day and the fund manager needs to sell 10 million shares as a result of some strategies that he is using, it will take him at least 10 days to complete the transaction. In addition, by flooding the market with oversupply of stocks means that the sales price becomes less and less.
Since market impacting costs are so called hidden costs or more hidden than stated sales charge and expense ratio, the only way to discover whether a particular fund is at a higher risk from higher market impacting costs is to based on three characteristics. First point to take note is that small caps have much lower trading volume and outstanding shares; hence funds that focus on them stand a good chance of impact market costs reducing returns. Second is that fund with larger asset base will of course have more of this problem than that with smaller asset base, the rationale behind is easy to understand. A fund with a large asset base will have a much greater number of outstanding shares to buy or sell for a given company’s stock or bond than one with a far smaller asset base. Thirdly and lastly, for high turnover funds that trade too much, it is not difficult to see that they stand an excellent chance of experiencing more of this market impacting costs.
c. Brokerage Commissions Costs
When we buy and sell stocks, we need to pay brokerage commissions. When fund managers buy and sell stocks, they also have to pay commissions. By right, since fund managers trade in far larger volume, they should be entitled to volume discounts, but there is a practice known as directed brokerage which regulators of financial industry banned a few years ago in the year 2004, whereby funds opt to pay more for the trading fees in exchange for placing their mutual funds on the brokerage’s preferred list. Some may still preferred to pay more for research data as of now, though the research data may at the end of the day be useful in achieving higher returns for the fund involved.
5. Strategic Tax Consideration
You can choose to buy mutual funds through yourself which is taxable or a tax shelter vehicle like 401(K). In the simplest sense, it is wise to buy mutual funds with high turnover rate through tax shelter vehicle like the 401(K) instead of through yourself. Vice versa, considering holding municipal bond funds, low turnover funds and mutual funds that are tax managed by yourself and need not through 401(K).
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