Zeroing in on Mutual Fund Expenses

Zeroing in on Mutual Fund Expenses

While reading the comments below regarding mutual fund expenses, keep in mind that at Centurion Advisors, we use individual stocks, individual bonds, and low-cost ETFs in portfolios where it is appropriate, typically those that have at least $200,000 to invest. As a result, the individual stock and bond portion of the portfolio, which is usually the bulk of the investments, carry an expense ratio of 0%. Our investors still pay us a fee to manage the portfolio, typically between 1.25% and 0.50%, and cover transaction commission charges to the custodian who holds the assets, but outside of these fees and charges, there are no underlying "expense ratios" as with mutual funds. Lastly, there are other benefits to directly owning stocks and bonds rather than through mutual funds, especially tax efficiency and management, control and transparency.

As investment options continue to expand and competition for investment dollars increase, the mutual fund industry is coming under increasing scrutiny for the expenses charged in many mutual funds. With the advent of no-load mutual fund, index funds s and exchange-traded funds, many investors are questioning the reasonableness of expenses charged by many of the industry’s more popular funds.  In times of double-digit market gains as have been experienced in recent years, mutual fund expenses are less of an issue, but, as market volatility increases and investors pare back their expectations, expenses, and their effect on total returns, suddenly becomes a bigger issue.

With literally thousands of mutual funds from which to choose, it becomes much more important to weigh all factors when comparing fund choices. Investors have always looked at fund performance as a primary point of comparison. But, as they have learned, often the hard way, the past performance of a mutual fund is no indication of how it will perform in the future. Few funds are able to consistently outperform the stock market indexes, and fewer funds have demonstrated any capacity to repeat earlier top performances. But, there is one constant among all mutual funds that can be measured, weighed and compared, and that is expenses, specifically the fund’s expense ratio which is a measure of the fund’s operating costs. Higher operating costs will result in a reduction in the fund’s return on investment.

Mutual fund salespeople have long argued that funds with higher sales loads or expenses outperform no load or low expense funds. That has proven to be completely false. In fact, studies have clearly shown that, collectively, funds with lower expense ratios generate more consistent returns and outperform more expensive funds over time.  This is not to suggest that you shouldn’t consider expensive funds, but it does suggest that the expense ratio is a critical factor when it comes to long term fund performance.

Understanding  Expense Ratios

Investment sites such as Morningstar have done much of the work for you in breaking out the expenses and expense ratio of the thousands of mutual funds it analyzes.  What’s more is they provide for easy, direct comparisons with other funds in related investment categories, so you will be comparing funds with similar objectives and management styles.

This comparison format is extremely useful for narrowing down your choices, however, there are other factors not included in the expense ratio that weigh heavily on the overall investment cost and long term performance of the fund.  For instance, the portfolio turnover rate – the rate at which the investment managers buy and sell stocks – can increase the investment costs if the rate is high. When stocks are sold frequently to capture short term gains, the portfolio is taxed on the gains and that cost is passed on to you in the form of reduced returns.

Additionally, the expense ratios don’t reflect other costs such as fund redemption fees or sales charges. Not all funds include these charges, but where they exist, they are paid directly by the investor so they aren’t included in the expense ratios.

Load vs. No-Load

With so many fund choices, investors may not have to consider funds that charge sales loads (commissions) or 12b-1 fees (annual sales fee).  But, it’s not always wise to step over a dollar just to save a dime. While no-load funds may seem like the better choice, it’s important to carefully examine the investment management fees.  Some fund companies will try to make their funds more attractive by eliminating the sales load, but then they will recoup the lost revenue by increasing other fees.  Just a half-point increase in the annual management fee could extend the expense break-even point of the fund out several years.

A load fund with very low management fees or expense ratio, could very well achieve a break-even point much sooner. The problem is that the fund analysis available through sites like Morningstar don’t factor in sales loads, so you may have to calculate the true break-even point on your own. It is also important to note that many load funds enable IRA investors to buy shares typically available only to institutional investors. These shares can often times be purchased without a sales load and with lower minimum investment requirements.

Expenses are Only a Part of the Story

Expense ratios should always be considered when selecting mutual funds for your long term investment portfolio. But, it’s important not to ignore other key factors that will help you determine how closely a mutual fund actually matches your investment profile including your tolerance for risk. Measures such as the Sharpe Ratio or the Alpha Ratio are key indicators of a fund’s relative volatility and its risk versus the stock indexes, which, in the long run, can be far more important than the expense ratio.

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.

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Investment Advisory Services offered LifeStyle Asset Management, Inc. ("LSAM").  LSAM is registered as an investment advisor with the state of Texas.  The firm only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements.  Registration does not constitute an endorsement of the firm by securities regulators and does not mean that the advisor has attained a particular level of skill or ability.  The firm is not engaged in the practice of law or accounting.

Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any securities.  Investments involve risk and unless otherwise stated, are not guaranteed.  All investment strategies have the potential for profit or loss.  Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein.

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