Costs come in many flavors, some very obvious and some much less so.  The most common types include loads, on-going expense ratios and trading costs.

Loads

There are two types of funds: load and no-load funds.  Load is just a fancy term for a sales charge.  Traditionally brokers were the ones selling load funds and their compensation was the load.  Loads can be structured as either   front-end or back-end.  The difference is whether you pay the fee at the time you buy the fund or when you sell the fund.  Typically front-end loads are in the 5% range and back-end loads are in the 2-3% range.  The bottom line is this is money taken out of your pocket to compensate a sales person, and there is ALWAYS a no-load fund with comparable performance.  We would never recommend buying a load fund.

Expense Ratios

All funds have something called an expense ratio.  This is the annual fee you pay for the fund managers services, administrative costs of running the fund, interest costs (for funds that short securities) and marketing costs (called a 12b-1 fee).  These fees are done as a percentage of your assets in the fund and can run anywhere from 0.05% for something like an S&P 500 index fund up to several percentage points for something like an actively managed long/short commodity fund.  When you see performance numbers reported for a fund, these costs will already be baked in.

Trading Costs

Every time a manager places a trade in the fund, there are 2 additional costs to you as the fund holder.  Neither is included in the expense ratio, and you will never explicitly see them, but these costs will be taken from the funds assets under the covers and will affect the ultimate performance of the fund.   The first cost is the commission the fund pays to whoever executes the trade for it.  The second is known as the bid/ask spread cost.

When a stock is bought or sold, it is done through a middle man.  The middle man sells stock to a buyer at the ask price and buys stock from a seller at the bid price, pocketing the difference.  To make this clear, lets use an example.  McDonalds recently traded at a bid of $94.76 and an ask of $94.78.  If I wanted to buy McDonalds at the market price, I would pay $94.78 per share.   However, if I wanted to sell McDonalds stock at the current market price, I would only get $94.76.  2 cents a share may not seem like a lot, but over time, if I am doing a lot of trading, those pennies add up.

Consequences

I mentioned in an earlier post that active funds have a poor track record against passive funds.  One of the reasons is that the manager has to not just out-perform the index, but he has to outperform the index + the difference in all of the costs involved.  Lets use another example to illustrate this.  Say we plan to buy a fund whose objective is to track an index that we expect to average a 7% return over the long run.  Lets also say that the fund has an expense ratio of 1.5% and incurs trading costs equal to 0.5% per year.  For the manager of the fund to simply match the index, his investments will need to make 7%+1.5%+0.5% = 9% per year.  Thats 29% more (9%-7%/7%).  Yikes!

The bottom line is that while you shouldnt pick a fund solely based on its costs, it is a criteria you should consider.  Its like having to carry extra weight around with you all day long.  Perhaps doable, but it certainly makes your life harder.

If you are investing in a taxable account, what you really care about is your return after you pay taxes.  This is heavily influenced by how much trading a fund does (known as turnover). whether the trades result in short-term or long-term gains and whether the manager tries to offset gains by selling some of his losers.  Recent changes in the law now force fund companies to give you some of this data in their prospectus.  Looking at this information will give you a pretty good idea of how tax efficient the fund is, but you should pay attention to their assumptions about tax rates, as your results may be higher or lower depending on your personal tax situation.

The key takeaway is you want to consider after-tax returns when comparing funds in a taxable account.  Like high expense ratios, high turnover is simply another anchor around the fund managers neck.

One often overlooked criteria investors need to consider is the risk/return ratio.  Many investors simply pick the fund with the best recent historical performance in the category they are interested in.  The potential problem with this is the fund may be taking huge risks to achieve those returns, and if the performance period the investor is evaluating doesnt cover a bear market period, they may be in for a very rude awakening.  The good news is theres a simple metric most fund screening tools provide to help compare funds risk-adjusted performance.  Its called the Sharpe Ratio.  We wont spend time today explaining how it is calculated, but when comparing funds in a given category, the higher the Sharpe Ratio, the better the funds returns are after taking into account the risks they are taking.

Size may seem like a strange criteria to look at when picking a fund.  Heres a simple example showing why it isnt.  Would you rather have a managers 20 best ideas, 100 best ideas or 10,000 best ideas?  While we could quibble over the best number, Im guessing no one picked the 10,000 choice.  As a fund grows, a manager has to find more and more new market beating ideas to invest all of the new money.  The smaller the market the manager is targeting, the harder this is to do.

This fact is a major reason why funds that have done really well in the recent past tend to struggle.  Because they did well, they get accolades (like Morningstar 5 star ratings).  Those accolades attract a lot of new money to the fund.  The manager then has to invest those funds in ideas further and further down his buy list.  He may also struggle to get the money working quickly if fund inflows are too great.  This will increase his cash position, and in a rising market hurt his results.

On the other end of the spectrum, if a fund is too small, there arent enough investors to split up the administrative overhead costs.  This often leads to a higher than normal expense ratio, which ultimately affects returns.

The last factor we want to cover today is what a fund owns.  Most people assume they can rely on the name of the fund or its Morningstar category.  Wrong.  Fund managers can invest in whatever their investment policy says they can, and they are often given broad latitude.  To give you an example, I bought a fund a while back that was supposedly a small cap value fund.  Because I was a less knowledgeable investor at the time, it didnt occur to me to look at the funds investment policy or check out its current holdings.  I trusted the style category it was given, the name and its historical results.  Turns out the fund had 20% invested in gold.  Great when gold was hot, but it wasnt what I thought I owned.

Given that I am buying a fund to fill out a particular asset class in my overall allocation, I can end up over-owning some asset classes and under-owning others if I dont own what I think I do.  Not good.  It is also much harder to evaluate how a fund is performing if you dont compare it against an appropriate benchmark.

Hopefully youve learned a few things about how to evaluate prospective fund purchases today.  Later this week, keep your eyes open for our comparison between funds and ETFs.  ETFs are becoming a popular replacement for funds.  However, making the right decision for your portfolio requires understanding how they are different and the associated pros and cons.