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About the High Cost of Mutual Funds
. . . And What You Can Do About It

Most People and Mutual Funds Do Worse Than Average

It is maddeningly difficult to "beat the market." Indeed, most people and most mutual funds actually do worse than the market averages each year, for a very simple reason: the averages are just that – theoretical, numerical averages. They pay no brokerage commissions, they pay no fees, they pay no taxes.

If the stocks in your mutual fund were up 10% some year, that's fine – but how much were you up? There are fees. There are transaction costs. And outside a tax-sheltered retirement plan, there are taxes. As you can see from playing with our calculator, in some cases that 10% could be cut to 7% or less!

You may think, "Well, 7% isn't 10% – but at least it's 70% as much. I'm only giving up 30% of what I could have had if there were no costs." The funny thing is that, the way compounding works, that's not true.

Take $10,000. Yes, the first year it grows by $700 if it's growing at 7%, versus $1,000 if it's growing at 10%. So the first year, you get to keep 70% of the potential gain, giving up only 30% to costs. But look what happens with compounding. After 40 years, your $10,000 will have grown to $149,000 at 7%; but to $452,000 at the full 10%. You are leaving $303,000 on the table! That's not a mere 30% of the $442,000 gain you could have had – it's 68%. That makes you, in effect, just a 32% partner in your own success.

Over a lifetime, even 1% makes a huge difference. If you put away $2,000 a year for 50 years at 8%, you'd have nearly $1.25 million at the end. Not bad. Doing just 1% better, though, you'd come out more than half a million dollars ahead – just north of $1.75 million.

Here's our message: In trying to decide which among thousands of mutual funds to buy, or whether to keep one you already own, ignore last year's sizzling performance and the "star" ratings and the magazine covers that scream "The 10 Best Funds to buy NOW!"  Look past the marketing hype and focus on the costs. This is the most important thing to do – and what most people fail to do.

Decades of research have shown that superior past performance generally does not "persist," but that inferior past performance, when caused by high costs and taxes, generally does.

The truth is that good funds have bad years and bad funds have good years, and nobody can predict which funds will be the best stock-pickers in the future. Listen to Mark Carhart ("On Persistence in Mutual Fund Performance," Journal of Finance March 1997), who now co-heads the quantitative research group at Goldman Sachs:

"While the popular press will no doubt continue to glamorize the best-performing mutual fund managers, the mundane explanations of strategy and investment costs account for almost all of the important predictability in mutual fund returns."

In short, the familiar disclaimer that "Past performance cannot guarantee future results" should really read, "Past performance is largely useless in predicting future results."  Except when it comes to costs.

There are four basic kinds of costs associated with owning mutual funds:

These are paid to the company that manages the investment portfolio

These are paid to the broker or adviser that sells the fund and services the account.  In some cases, it's a straight up-front sales commission ("load") or a surrender fee you pay when you sell the fund. But other funds – "no-loads" – may charge an annual "12b-1 fee." It seems small compared with a sales commission – except that it nicks you year after year after year. (In still other cases, the fund manager simply uses part of its management fee to pay for marketing and distribution. You thought that hefty fee was going to a team of brilliant analysts, but some of it was going to pay brokers or buy ads.)

These are incurred by the fund as it buys and sells securities. Trading costs money, and it comes out of your money. There are brokerage commissions, of course. (And they are not always rock bottom. Sometimes, to keep its reported management fee low, a fund will pay for investment research with what are called "soft dollars" – higher commissions than they might otherwise have to pay.) Beyond commissions, there are spreads. With a Picasso, a gallery that would sell it to you for ten million might buy it from you for only five. With 10,000 shares of a stock, the spread between "bid and ask" prices will be much smaller – but meaningful nonetheless. And there's another aspect to this. If you or I want to trade 500 shares of stock, it rarely "moves the market." What we add to the supply (if we're selling) or demand (if we're buying) is insignificant. But what if, like a mutual fund, we were trying to buy or sell 200,000 shares – let alone in a hurry? We might sell the first 5,000 shares at 50, but have to accept as little as 49 or 48, on average, to move them all. Buying, we might find that our demand for these shares had bid their price up to 51 or 52 by the time we had gotten them all.

Mutual fund managers are generally sensitive to this, of course, and attempt to trade cheaply and wisely. But the same Mark Carhart quoted above found that, on average, a fund with 100% annual turnover gives up nearly 1% in transaction costs. A fund with 25% turnover would give up only a quarter as much. A fund with 300% turnover – three times as much.

Transaction costs are not incorporated in a fund's "total expense ratio." They are taken directly out of shareholder assets.

The fund itself does not pay taxes.  Shareholders who own the fund in taxable accounts pay taxes on dividends and capital gains distributed by the fund. And there's reason to think that many fund managers don't worry too much about this. Indeed, because they know shareholders feel good when they get distributions, some will actually realize gains unnecessarily, just to have something to distribute. This may be good marketing, but it's bad financial strategy.

No.

It would be different if the funds that charged the highest fees could justify them by turning in the best performance. Who wouldn't be willing to pay 1% or 2% a year more for a fund that could beat the market by 5% or 10% a year?

In practice, there's no evidence that higher-cost mutual funds earn higher returns than their competition. Quite the contrary.

Yes, some funds excelled last year. But – counterintuitive though it is – this tells you little or nothing about how well they will do next year.

In high school, as I have written elsewhere, you can be pretty sure an A-student this year will get good grades next year, also. Not always, but generally. In mutual funds, this is not the case. The market is fluid. A portfolio manager may ride a wave for several years with his particular investment style, only to capsize when things change. Or he may grow lazy or distracted (an affair of the heart? that new house on the fairway?) – or move to another fund. Even if you know he's gone, it's not practical to sell your shares and follow him with your money if, in so doing, you'd incur taxes or a new sales load.

The market is so competitive, with so many bright people (and not a few dumb people) canceling out each others' views, it is very hard to beat the averages even by 1% or 2% a year. Few do. And once you subtract the extra fees and costs an actively managed mutual fund will often incur – let alone any up-front sales commission – it just becomes so hard to win this way. Might there be a few lucky souls who do? Definitely. But the much easier way to assure reasonable investing success, relative to your friends and neighbors, is to focus on costs.

In these years of 20% and 30% gains in the market . . . of companies going public at $18 and closing their first day's trading at $93 . . . it's important to realize that the true long-term rate of return on U.S. stocks, after tax and inflation, has historically been only 3% - 5% per year.

I tell you this not to depress you, or even to help you make more realistic retirement-planning assumptions, but to bring into still higher relief the relative importance of an extra 1% or 2% in costs.

(The average historical total rate of return on the Standard & Poor's 500 from 1962 to 1997 was about 11.5%.  But that would not have grown $20,000 into $1 million, as your pocket calculator suggests. After taxes and inflation, you'd have had about $80,000 in 1962 purchasing power.  A lot better than nothing, and a lot better than the results from a savings account or government bonds. But a true rate of return of about 4%.)

It's not as much fun, but for most people the wisest strategy is not to try to guess tomorrow's hot stock or fund, but to keep for themselves as much of the market's return as they can, and to pay as little as they can in costs.

It is for precisely this reason that many smart people today don't try to beat the market. They merely try to match it, or close to it, by buying and holding a broad cross-section of stocks. This strategy is called passive investing, and it outperforms most actively managed mutual funds – especially in taxable accounts.

Ironically, most people who try to "beat the market" end up with mediocre results, while those who merely try to match it outshine the average investor.

One way to invest passively is with index funds that track a large set of stocks, such as the S&P 500 or the Wilshire 5000. This is so easy to do that it can be done at very low cost. (Some index funds nonetheless charge much more than others – check out any fund with our calculator before plunging in.) And because index funds basically just buy and hold – they don't wriggle around buying and selling in an attempt to beat the market – they generate little or nothing in the way of taxable capital gains until, years from now, you sell and take your profit. In the meantime, you have Uncle Sam's share of your money working for you, too.

Another way to invest passively is with securities that trade on the American Stock Exchange just like stocks. "Spiders," as they're affectionately known, mimic the S&P 500 and trade with the symbol SPY. "Diamonds" – DIA – mimic the Dow Jones. And there are other cousins as well that attempt to represent a broad range of mid-sized companies and of foreign markets. Some argue that these securities are even better than the cheapest index funds. I've always felt that for most individual investors it doesn't make much difference.

And if you're concerned the world would end if "everyone" indexed, click here.

Still another way to invest passively is to "do it yourself." Namely, to buy and hold a diversified portfolio of individual stocks and, in effect, build your own "personal fund" – a concept only recently made practical by the Internet.

Over the months to come, Personal Fund, Inc. will provide investors the information and tools to match, or nearly match, "the market" – not only saving dramatically on mutual fund fees in some cases, but also, for investors in taxable accounts, allowing them to control the tax consequences.

But our first step is to illustrate to mutual fund investors just how much potential gain they are giving up today – hence the Mutual Funds Cost Calculator. Indeed, we hope this Cost Calculator will continue to prove useful long after thousands of investors have begun building their own personal funds.

Register with us and join us on this interesting journey. Registration is completely free.

Click here to find out how much your funds cost.