Cutting the Costs of Mutual Fund Investing

by S. Andy Claybrook, CPA

Mutual funds, especially those invested in U.S. common stocks, have surged in popularity and availability during the past 10 years. An Individual Retirement Account or 401(k) savings plan invested in mutual funds has replaced a certificate of deposit and passbook savings account as the core investment of the American public. Only a few investors, however, give a second thought to the costs inherent in mutual fund investing, which in fact are a significant determinant of long-term investment performance. This discussion provides a broad overview of the issues presented by high mutual fund costs, and is not intended to offer specific investment advice. Each person's financial situation is unique, and it is important that readers consult a professional, such as a certified public accountant providing investment advisory services, if you have specific questions or need advice on developing an investment strategy.

An Emerging Issue

Investors in stock mutual funds have enjoyed once-in-a-lifetime returns during the 1995-1998 period. With the stock market appreciating at a 20-30 percent annual clip, many mutual fund shareholders have turned a blind eye to the underlying cost levels of their investments. Alert investors, however, are challenging costs, and the financial press is beginning to focus public attention thereon. Both the Wall Street Journal (1) and Forbes (2) have run excellent pieces on fund costs, and Securities and Exchange Commission Chairman Arthur Levitt continues to express concerns with what he considers inadequate disclosure of the negative impact of costs on investment returns. (3) Likewise, Vanguard Group founder John C. Bogle Sr. is still pressuring his peers throughout the fund industry to lower the cost burden on shareholders. Please do not misunderstand- I am not "bashing" mutual funds. If selected carefully and with an eye on the investor's objectives, time horizon, and risk tolerance, mutual funds remain excellent long-term investment vehicles. They provide convenient portfolio diversification and access to professional money management that the average investor otherwise may be unwilling or unable to acquire. Mutual funds are also a handy way to add exposure to asset classes (e.g., foreign stocks and/or bonds) in which it is often problematic to purchase and hold individual securities. These are substantial benefits, and fund providers clearly deserve to be compensated fairly for providing them.

Costs-More Than Meets the Eye

Many, but not all, of a fund's costs are included in its "annual expense ratio," which is stated as a percentage of the fund's net assets. The investment manager's fee, marketing and distribution costs, and other administrative and overhead expenses are typically included, and the ratio is widely published in the fund's prospectus and in financial newspapers and magazines. A much less visible element of a fund's total costs are transaction-related expenses, such as brokerage commissions, which are included in the net purchase or sales price of the fund's securities. Furthermore, some funds are increasingly utilizing various options and currency contracts for risk reduction or speculative purposes, further driving up transaction costs.

Upward Trend

One would reasonably expect that with the rapid growth of the mutual fund industry and its assets under management, economies of scale and increased competition would produce a declining trend in average fund expense per dollar invested. However, for actively managed funds, costs have risen steadily in recent years, and new shareholder assessments, such as "12b-1" marketing fees, have been imposed by some providers. The Morningstar mutual fund service has reported that in 1997 the average expense ratio for a diversified U.S. stock fund was 1.41 percent as compared to 1.12 percent in 1978. (4) The net result to the unsuspecting fund investor is a cost structure that can often be punitive, particularly if accompanied by sales charges and/or high portfolio management fees charged by an investment advisor or brokerage. If higher costs produced higher returns, then of course there would be no complaint. However, additional research conducted by Morningstar has concluded that, in the aggregate, above-average fund costs do not produce above-average returns, and in fact, just the opposite appears to be true. (5) The higher the cost hurdle, the harder the fund manager must work to "add value" sufficient to overcome it. Unfortunately, only a very few managers seem to be up to this task over the long term, and often their portfolios must assume a very high risk/volatility profile to match or exceed benchmark returns (e.g, the S&P 500 or Russell 2000 indices).

Long-Term Damage

The long-term impact of high mutual fund fees on a portfolio's growth can be surprisingly corrosive. For example, over a 20-year period $100,000 earning 12 percent annually yields about $965,000, but if the return decreases to 11 percent due to "extra" annual fund expenses of 1 percent, the value after 20 years is only about $806,000, a whopping 16.5 percent decrease. Minimizing return "leakage" due to high fund expenses can be a painless, risk-free way to boost long-term investment returns.

Consider this recent comment from legendary investor Warren Buffett: (6) "That's why we say expenses are very important. People are investing in a very expensive way and it's going to take a very big bite out of their net return over a 10-20 year period. It hasn't been noticed so far because some people are getting 20 percent gross returns and they don't care if it costs 2 percent or not." Of course, in performing due diligence on mutual funds, advisors and investors should not focus exclusively on fees and expense ratios. However, fund costs and expense levels clearly do matter, and shareholders should monitor them closely to ensure that they are receiving "value for their dollar," in terms of both investment performance and services provided. Of course, the same holds true for professional assistance provided by a broker or investment advisor, whether he or she is compensated by fees, commissions, or some combination thereof.

Wringing Out Costs

How can a mutual fund investor or advisor hold costs to a minimum? Consider the following strategies: Indexing- Passively-managed index funds make very attractive core portfolio holdings, especially for taxable accounts. These funds have very low costs, minimize taxable capital gain distributions, and produce returns approximating a broad market index, such as the S&P 500 or Russell 2000.They are also available for purchase without sales charges or 12b-1 fees. However, be aware that with an index fund you assume all of the volatility and investment risk of its benchmark index. Annual expense ratios- Look for funds with annual expense ratios no higher than the average for the type of fund you are considering. For actively-managed U.S. stock funds, a ratio below 1.4 percent is preferable, but consider the fund's long-term performance, downside volatility, and investment philosophy, as well as minimum investment thresholds and any account transfer restrictions. Cheaper is usually, but not always, better. Buy-and-hold philosophy- Funds following a buy-and-hold investment approach eschew the frequent trading that produces large capital gain distributions and high commissions. Also, such funds frequently have lower overhead costs, the benefits of which are typically passed along to shareholders via a lower expense ratio.

Conclusion

The issue of unreasonably high mutual fund costs is just beginning to receive the publicity and scrutiny it has long deserved. There is no substitute for sober and unbiased research in selecting a mutual fund, and its cost structure and fee levels are a crucial factor in this analysis. Mutual fund investors paying above-average fees and expenses should demand above-average long-term performance and shareholder service. If performance and service are lacking, there are now plenty of lower-cost, shareholder-oriented funds and fund families available for investor consideration and due diligence.

References

Wall Street Journal, "Mutual Funds Aren't Always Ideal," August 14, 1988
Forbes, "Costs Matter," August 24, 1998
Financial Planning, "Fund Fees Likely to Stay Fat," July 1998
Smart Money, February 1999, p. 39
Morningstar commentary, "The Rising Tide," October 11, 1998
Investment News, June 28, 1999

About the Author

S. Andy Claybrook, CPA, CFP is a member of the Tennessee Society of Certified Public Accountants Personal Financial Planning Committee. He provides independent, fee-only personal financial planning and investment advisory services in Franklin, TN. A CPA since 1980, he is also a certified financial planner, chartered mutual fund counselor, and registered investment advisor in Tennessee. He may be reached via e-mail at saccpa@worldnet.att.net.