Zeroing in on Mutual Fund Expenses
At Safe Harbor we believe that the key to successful long term investing is maintaining an appropriate asset allocation among stocks, bonds, and cash reserves that is congruous with risk tolerance, time horizons, and return requirements. We further believe that investors are best served by investing in companies and funds that have demonstrated sound management and growth over extended periods of time.
We believe that markets are efficient and, while past performance can be used as a guide, it is never a guarantee of future performance, and future performance is unpredictable especially over the short term. Because of this, we pay close attention to investment costs as they are very predictable and can materially affect total return.
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 from which to choose, 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 has proven to be completely false. In fact, studies have clearly shown that, collectively, 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.
Understanding Expense Ratios
Investment sites such as Morningstar have done much of the work for you in breaking down the expenses and expense ratio 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 load commissions or distribution costs. But, it’s not always wise to step over a dollar just to save a dime. While we at Safe Harbor unabashedly recommend no-load funds and passive investing to our clients, there are some cases where it may appear that no-load funds may seem like the better choice but 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 don’t factor in sales loads, so you may have to calculate the true break-even point on your own.
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.
Have questions? Please call or email the Safe Harbor team and we can help you better manage your own money.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2014-2015 Advisor Websites.