Inflation is on the rise, and that means a bigger dent in the real rate of return on your investments. One way to stay a step ahead is taking a closer look at the various fees that can ding your nest egg. Since most people who save in defined contribution plans and individual retirement accounts stash their savings in mutual funds, I’m going to focus on those costs in this post.
Fees and expenses are related to the costs of managing a mutual fund; marketing it to investors; and sales commission that can occur when you buy or sell a fund. Sometimes the fees are fairly obvious, but some of them are deceptive—you don’t discover them unless you carefully read the fund’s prospectus. Here are a few big fees to examine when looking for a way to boost your investment returns:
Expense Ratio: This represents the fund’s total annual operating expenses (including management fees and other expenses) expressed as a percentage of average net assets. If a fund with $100 million in assets charges $1 million to manage the fund, that’s an expense ratio of 1 percent. This money comes right out of the return that would otherwise go into your pocket.
But expensive management doesn’t necessarily correlate with superior returns: Morningstar research shows over the long-term, lower-cost funds outperform those with higher costs. To figure out what a fund costs you every year, take your total investment and multiply by the expense ratio. (You can find the expense ratio at Morningstar.com; pull up your fund’s report and click “fees and expenses.”) Morningstar recommends investors pay no more than 1 percent for a stock fund or bond fund, and no more than 1.5 percent for a small-company or foreign fund.
To avoid higher expenses, consider an index fund, which tracks the performance of benchmark indices such as the S&P 500. Their expenses are dramatically below those of actively-managed funds – and only 32 percent of actively-managed funds beat the returns of the S&P 500 in 2006, according to Morningstar.
In a 2007 interview, Warren Buffett called index funds are the best option for investors who don’t have the time to research companies. “Just buy a low-cost index fund and keep buying it regularly over time, because you’ll be buying into a wonderful industry, which in effect is all of American industry,” Buffett said. “If you have 2 percent a year of your funds being eaten up by fees, you’re going to have a hard time matching an index fund in my view.”
According to data from Lipper Inc., the industry’s average fund expense ratio is 1.27 percent. By contrast, the Fidelity Spartan 500 Index Fund charges an expense ratio of 0.10 percent. The Vanguard Total Market Index Fund charges 0.15 percent.
A Load or Sales Charge: This can be a front-end load, charged to pay a broker upfront when you buy the fund; or you can get hit with a back-end load when you sell the fund. There are also level loads that can be charged over a period of years. Look for a no-load fund—but watch out for sneaky funds that call themselves no-load and then whack you with fees disguised under other names, such as purchase fee (which goes to the broker upfront) or redemption fees (charged by the fund when you sell or redeem shares).
A high load, combined with lofty management fees, can be a disaster for investors. Morningstar recently reported on how investors are getting taken for a ride buying government bond funds from brokers.
Considering investing in a mutual fund? The Securities and Exchange Commission offers an online Mutual Fund Cost Calculator to help figure out the toll that fees and expenses will take on your investment over time. See www.sec.gov/investor/tools/mfcc/mfcc-int.htm.