What's your mutual fund really costing you?

Nation's Business, July, 1996 by Randy Myers

No doubt about it, mutual funds are a convenient way to invest in the stock and bond markets. And they're often economical. But not always.

Knowing which ones are economical is important; the costs of a fund can make a big difference in how much you earn. Over a period of years, high costs can pare hundreds, thousands, even tens of thousands of dollars off the value of your investment account.

Consider two no-load funds, one whose costs equal 2 percent of its assets, the other with costs of 0.5 percent. Assume both generate gross earnings-or profits before expenses--of 8 percent annually. After 10 years, an investment of $10,000 in the high-cost fund would be worth $17,900, while an equal investment in the low-cost fund would be worth $20,600.

Why? Because the net return of the high-cost fund is 6 percent, while the net return of the low-cost fund is 7.5 percent.

John J. Brennan, president and CEO of the Vanguard Group of mutual funds, which is widely noted for its commitment to low costs, notes that of the three variables that affect investment results (risk and return are the other two), cost is the only one you can easily control.

"You can sense what your risk will be based on the type of investment, but it's impossible to forecast what the return will be," Brennan says. "All other things being equal, why not pay less while taking the same risk for the same prospective return?"

To be sure, lower costs don't always lead to higher investment returns. Some high-cost funds have terrific performance records, but they are the exception.

You can find a fund's expense ratio (its annual operating and marketing expenses expressed as a percentage of its assets) in its prospectus, the legal sales document the fired is required to provide to prospective investors. The ratio reflects, among other things, expenses for providing shareholder services, supervising the fund's operation, directing the investment of the fund's assets, and providing a profit to the fund's adviser.

For the nearly two-thirds of funds that charge them, the ratio also reflects any annual 12b-1 fees levied on shareholder assets each year to help pay for marketing and distribution of the fund, typically through a commissioned sales force. (The 12b-1 fees are named for the section of the Investment Company Act of 1940 that permits such charges for marketing and distribution.)

While performance figures published for mutual funds take expenses into account, they do not reflect another potential cost to shareholders-the one-time sales loads, or commissions, that some funds charge investors every time they purchase shares (in the case of front-end loads) or sell them (back-end loads).

Front-end loads typically range from 4 to 6 percent of the purchase amount. If you pay a 5 percent front-end load on a $1,000 investment, the fund actually invests only $950 of your money. You'd have to earn at least 5.3 percent on that investment in its first year just to break even.

Back-end loads, or "deferred sales fees," usually start at levels comparable to front-end loads, but they often decline by i percentage point per year thereafter until they disappear. That makes them palatable to people who keep their funds for many years but costly for those who redeem shares or swap them into other funds before the fees expire.

Funds that charge sales loads frequently argue that they give shareholders better investment management or better service. But there simply hasn't been conclusive evidence to support the first claim, and quality of service is a subjective matter-- smart shoppers should ask what extra services they're getting and then decide if they're worth the expense.

In addition to sales loads and operating expenses, mutual funds' performance can be affected by hidden costs. The most significant of these are the commissions all mutual funds pay to brokers for buying and selling securities for them (just as you would pay a broker to buy or sell stock for you).

These costs aren't broken out in fund documents, but they are reflected in the fund's total return figures, and they present another hurdle to outstanding performance.

Naturally, a fund that buys and sells securities frequently will incur higher transaction costs than a comparably sized fund with a buy-and-hold strategy. The former is also likely to generate more short-term capital gains, which, for shareholders, are taxed as ordinary income, not at the more favorable rates available for long-term capital gains.

You can gauge the pace at which a fund buys and sells securities by looking at its turnover rate, which measures sales and purchases of securities as a percentage of the funds average assets.

The average domestic stock fund has a turnover rate of about 81 percent, the average domestic bond fund 107 percent, according to Morningstar, Inc., an investment-research firm in Chicago. The higher the turnover rate, the higher, in general, the transaction costs.

In the end, of course, choosing a mutual fund with low costs won't guarantee high returns. "But unless you can forecast that the fund you pay higher expenses for will outperform by enough to make up for those expenses," says Brennan, "the lower-cost fired will give you a head start against the competition in the investing sweepstakes."