ARE YOUR FUND EXPENSES JUSTIFIED?
High priced mutual fund managers add to a fund’s expenses and can only justify their expense if they can consistently beat the market. If you are paying for expensive managers, but still getting market, or below market, returns you may want to explore an “Index Fund”.
Index funds are designed to track a specific list of stocks and/or bonds and therefore don’t require much investment management, therefore offering lower fund expenses. The decision regarding which instruments to invest in has already been pre-determined by an index such as the Standard and Poors 500 (S&P 500).
The fund managers simply invest in the same companies that make up the index. As the companies within the index increase or decrease in value, so does the index fund in aggregate.
Many investors choose to invest in mutual funds either directly with a fund family, or through a brokerage account or within a 401k or other retirement plan.
Investors working with a broker or adviser may simply take the recommendation of their planner when it comes to choosing which mutual fund to invest in. Most do-it-yourselfers end up choosing a fund based singularly on past returns (a poor predictor and no guarantee of future results). But did you know that one very important element to consider when choosing a mutual fund is the fund’s expense ratio.
The expense ratio of the fund represents the cost of running and administering the fund. The largest component of this expense is usually the management fee paid to the fund managers for their management.
What are you paying for? Well, you hope you are paying for the financial wisdom to pick and choose, buy and know when to sell, the underlying stocks, bonds and other financial instruments that comprise the fund. If you are investing in most of the same companies that comprise an index, you would benefit from choosing a similar index fund and receiving lower expenses.
EVEN SMALL DIFFERENCES IN FUND EXPENSES CAN GREATLY IMPACT YOUR RETURNS OVER TIME
Whether you are working with an investment professional or investing on your own, you will want to consider a fund’s expense ratio as well as it’s past returns (and various other topics to be addressed in other posts) before choosing any particular fund.
Thankfully, the information about a fund’s expenses is available in several places including a fund’s prospectus and numerous online tools that track and analyze mutual funds.
Once you have determined your diversification and allocation strategy for your portfolio and you are ready to choose a fund, take a look at the fund’s expenses. Think of it this way. If you have a choice of taking your car to either of two mechanics for repairs, and they perform the exact same work and do the same quality job, then you will naturally wish to choose the mechanic that is the least expensive.
But if one mechanic charges more than the other, and can deliver 20% more fuel efficiency, you may be willing to pay more for his services. This is an overly simplistic example, but I think you will get the idea. Paying a premium for investment management is justified if the fund managers can deliver returns greater than the base index. Otherwise, you may be just as well served to choose a passively managed index fund with lower expenses.
To be clear, the fees discussed in this post are separate and distinct from any sales commission or “load” you may experience when purchasing a mutual fund. The fees discussed here are charged by the investment managers who are managing the fund after you decide to make a purchase/investment.
Unlike your broker, you will probably never meet these “investment managers” in person. Most retirement plans do not charge a commission or fee to make your initial or subsequent investments. Consult your plan sponsor for details regarding your retirement or 401k plan.
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