ChuckJaffe

Are your mutual funds worth what you are paying to own them?

Most investors answer that crucial question backwards, saying that the fund’s results either do or do not justify the money the percentage that management keeps for itself.

The problem is that investors should answer that question looking forward, and try to come up with the reasons they believe the manager can justify his or her paycheck.

What makes that hard to do is that most investors don’t have a good idea of what is reasonable to pay for a mutual fund.

WSJ.com

The Investment Company Institute — the fund industry’s trade association — came out this week with its annual look at fund expenses, crowing about how the trend in recent years has been going in the right direction.

Indeed, while fund ownership, on average, costs less than in the past — and while the statistics show that investors tend to concentrate on issues with low costs — few fund buyers properly factor costs into the buying equation.

Costs matter because they are the one thing that an investor can count on; returns, by comparison, will vary, but management takes its cut regardless. So if a large-cap growth fund is up 8% in a year and charges the average expense ratio for the category — 1.27%, according to Morningstar Inc. — the fund is going to be up 6.73% for the year, the gross return for the fund minus its cost.

Money, however, typically flows into lower-cost funds. The “dollar-weighted average” expense ratio for large-cap growth funds — the average paid by investors who own funds in the category — is 0.80 percent, according to Morningstar. That means that if the fund can generate a gross return of 8%, their return from the fund will be 7.2%

That difference adds up over time. If the market averaged that return each year over 10 years, the investor in the fund with the lower expense ratio would double their money, while the one facing higher costs will come up about 5% short of that.

That’s why some investors are so adamant about owning low-cost funds that they let the means — the ongoing costs — justify the ends, namely whatever the fund delivers.

But low costs simply mean that shareholders will keep more of what the fund earns in the marketplace; they don’t guarantee great returns.

And that’s why another sub-set of investors expects the ends to justify the means, ignoring costs with the expectation of superior returns. Indeed, you could argue that kind of thinking is what drives the hedge-fund world, where the standard fee is 2%, plus 20% of the profits, a lot higher than the average mutual fund, but where investors are expecting higher returns than they could get in traditional vehicles.

Part of the problem is that while average expense ratios are going down, most investors don’t know how to measure if a fund’s costs are high or low.

According to Morningstar Inc. the average stock fund — regardless of type — charges 1.36% for expenses, while the average bond fund prices out at 0.99%. The dollar-weighted averages — which show what the typical investor is actually paying — are 0.76% for equity funds and 0.61% in bond funds.

Depending on the assets the fund buys — and some of the techniques/difficulties involved in trading those securities — the average costs range from 0.75% for near-term (2011-2015) target-date funds to 2.53% for managed futures funds.