Fees, Charges & Taxes – How To Make Them Go Away

"Beloved, I pray that you may prosper in all things and be in health, just as your soul prospers.” (3 John 1:2 World English Bible)

The Downside of Mutual Funds

By no means are mutual funds the perfect investment. They do have disadvantages. Some of these flaws can cost you a small fortune. One of the biggest drawbacks is the fees thy charge.

In the short term, the impact of costs may appear modest, but over the long run, investment costs become immensely damaging to an investor’s standard of living. Think long term! –John Bogle, founder of the Vanguard Group

Depending on the research you choose to rely on, the average cost to own an actively managed fund is around 2-2.5% per year. That is an average, which means some funds charge a great deal more.

All mutual funds charge on expense ratio, which represents a percentage of the assets they manage. Everyone needs to get paid, after all. The average portfolio manager makes a little less than $500k per year. You help pay his or her mortgage and Porsche payments. There are also transaction costs because managers buy and sell securities on a regular basis. Some funds have 100% turnover[1] or more during the course of a single year. That is a lot of trading, and who pays the costs? You do.

You may also pay a sales charges, among other fees. People who sell you these investments need to get paid as well. According to the Investment Company Institute Fact Book[2] the average sales charge for stock funds was 5.4%. The average bond funds were 3.9%. Believe it or not, another fee some MF companies charge is called a 12B1. That is to cover advertising and marketing expenses. Isn’t that nice of them?

Over the years, I have had several potential clients come to see me for advice or a second opinion on their investment portfolios. I can’t tell you how many times these folks had no idea how many fees they were paying their fund company. Some even insisted they were not paying any fees. My question to them was, ‘Who works for free?’

Most of the disclosures about costs and fees are buried in the prospectus, which virtually no one reads—except me. The regulators, in their infinite wisdom, think it is the investor’s best interest to have a MF company print a 200-page document written in legalese, which no one understands except those with a law degree. The fees are there but good luck trying to find them.

Last, but not least, you pay the MF company a maintenance fee for the privilege of letting them maintain your account and send you quarterly statements. Of course, if you want to save the planet (who wouldn’t) the MF company will allow you to download your statement instead of mailing them to you. Same fee, but the earth is a better place to live, and the MF industry keeps getting richer.

So. let’s bottom line it. If you add up the fees, charges and cash drag[3], you are at 2.27%, plus any initial sales charges you paid, give or take a few basis points. What does that mean for the average investor? If your fund had a gross return for the year of 10%, you net 7.73% after deductions. If you paid a sales charge or load of, say, 5% on an initial $10,000 investment, you received a 7.73% return on $9,500 or a paltry $234. That is less than a 3% total return on your investment dollars.

Think about that for a minute. You put up 100% of the initial investment capital, you assume 100% of the market risk. but you only receive a fraction of the gains. Oh, and by the way, they get their 2.27% even if your MF had a down year. How does that work? If the gross return was minus 10%, your account will decline by 12.27%. They still need to get paid for the fine job they do. Lovely, isn’t it?

Here is something to ponder: The difference between paying 1% in annual fees versus 2% on a $100,000 investment over a 30-year period will cost you about $200,000. I hope you grasp the importance of low fees. $200k is a lot of money! High fees can severely damage your economic well being.

Are you beginning to see that MFs have a parasitic nature?

Next, let’s talk taxes.

Long-term capital gains and dividends are normally taxed at lower rates than ordinary income tax rates. Short-term capital gains (shares held for one year or less), however, are generally taxed as ordinary income tax rates. Why is that important? A Morningstar analyst estimated the average turnover ratio (explained earlier) for a managed domestic stock fund was 130%, creating a great deal of short-term capital gains which are almost always taxed at a higher rate.

Another big problem with mutual funds is underperformance. Roughly 90% of all actively managed funds failed to beat the S&P 500 index over a 15-year period. That being the case, most investors are grossly overpaying for mediocre returns. Based on the evidence, investors should seriously consider stacking the deck in their favor by investing in an index fund that tracks the S&P 500.

It has been shown that active managers are not able to outperform sufficiently to offset the costs that they impose on investors. –Jeremy Siegel, author of “Stocks for the Long Run”

Here is another factor to consider: According to the American Association of Individual Investors, only 6.8% of solo MF managers last ten years. Morningstar states that 34% of all managers change jobs in just one year alone. That can be very problematic. Suppose you do your research and find a MF you really like. It has a great long-term track record with lower than average fees. You buy the fund, only to find out a year later that your fund manager has moved on to greener pastures. Needless to say, the MF company doesn’t give you a heads up because they don’t want their investors to make a mass exodus. So, what do you do? It depends. Does the new manager have a great track record, or is it someone straight out of business school with no practical experience? You may want to consider transferring your account to the company your old manager now works for. Sometimes it makes more sense to buy the manager and not the fund.

Either way, do your homework before you decide.

One final point: According to Morningstar, about 50% of these professional money managers don’t invest their own money in the funds they run. That is certainly worth sustained reflection, don’t you think? I can’t fathom why anyone would invest in a fund its manager doesn’t invest in. You would think an ethical manager would want to show they believe in their fund and are willing to pay the same costs and taxes their shareholders pay. I don’t think you would see this kind of behavior in a monastery. I also don’t think you will disagree with me; manager ownership is a clear signal of commitment (or lack thereof) and faith in the funds they manage. If the most reliable advocate for a product or service is its user, and only about 50% of portfolio managers invest their own money in the funds they manage – what does that sat to you? It speaks volumes to me!

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[1] Portfolio turnover is a measure of how frequently assets within a fund are bought and sold over the course of a year.

[2] 2011 edition

[3] MFs need to keep a portion of their assets in cash (around 2-5%) for new purchases and redemptions. The interest rate on cash is generally close to nothing, thus lowering portfolio returns because they are not 100% invested.