By Gail MarksJarvis, Pioneer Press, St. Paul, Minn.
Knight Ridder/Tribune Business News
21 November 2004
Saint Paul Pioneer Press (KRTBN)
Nov. 21--You probably are wasting more of your hard-earned money on your mutual funds than you realize.
Although you might be a frugal investor who tries to keep your costs down by watching the expense ratios in the mutual funds you buy, you could be missing a good chunk of your actual costs.
A study by three finance professors shows that about a third of the costs investors pay for the average mutual fund never show up in the expense ratio -- or the number in a fund prospectus that supposedly reveals your costs.
Besides the annual operating costs in the expense ratio, investors are spending another 0.41 percent of their assets for hidden costs. Those costs cover commissions and other expenses related to buying and selling stocks in funds.
Edward O'Neal of Wake Forest University and Jason Karceski and Miles Livingston of the University of Florida analyzed 5,000 different mutual funds.
They found that the average expense ratio for funds is 1 percent. But when hidden fees are added, the investor's actual cost is 1.41 percent of his or her assets.
So if you have $10,000 invested in a mutual fund, you are paying $141 a year in fees on average. It's significantly more for small-cap funds, growth funds and international funds. In fact, the actual costs for a small-cap growth fund average 2.78 percent, O'Neal says.
Paying $141 a year might sound like small potatoes. But the effect on a nest egg over a lifetime of investing can be tremendous because of the power of compounding, says O'Neal.
Imagine two investors. One puts $10,000 into the average mutual fund charging 1.41 percent a year, and the other puts the same money into a low-cost alternative -- an index fund. The index funds don't hire managers to cherry-pick the best stocks, so they can charge only 0.314 percent on average, according to the study.
Assuming both funds earn a 10 percent annual return on their investments, the investor's $10,000 would grow to $51,927 after 20 years in the average fund, says O'Neal. But the investor in the low-cost index fund would have $63,537.
"These hidden costs would never be acceptable for mortgages or automobiles, and yet mutual funds are the cornerstone of retirement," says O'Neal.
Financial advisers who sell high-cost funds often tell clients the extra cost is worthwhile because a smart manager builds a person's nest egg effectively. But O'Neal says academic research refutes this: Smart managers outperform the stock market only for short periods, and historically, the stock market -- which is mimicked in index funds -- provides a higher return.
The primary reason is costs. Stock picking is difficult, and the market rises and falls unpredictably. But cutting costs is a sure thing: The lower the cost of a fund, the more money an investor gets to keep, says O'Neal.
Consequently, he and many other academics believe in choosing low-cost index funds. But even investors who want actively managed funds can pocket more of their returns if they keep their eye on costs, he says.
Doing the analysis the professors did is virtually impossible for the average person. The analysis comes from numerous documents that aren't readily available to the public, which fuels the argument that the Securities and Exchange Commission should change reporting requirements so costs are obvious to investors.
But in the absence of that data, steps can be taken to avoid hidden costs.
The simplest approach: Buy low-priced index funds. But if you do, make sure you pay attention to their costs. Some index-funds sold by brokers and financial planners can be as pricey as other funds. Yet running index funds takes no great acumen, so there is no reason to buy an index fund with expenses exceeding the average -- 0.25 percent.
If you want to keep using actively managed funds but want to avoid high hidden costs, focus on the "expense ratio," says O'Neal. While that misses substantial costs, he says that high hidden costs tend to show up in funds that also have high expense ratios.
In addition, Gregory Carlson of Carlson Capital Management in Northfield says investors should check the turnover rate in their funds. That's a number easily found in a prospectus or available from an adviser. It refers to the number of times a fund manager dumps existing stocks and buys new ones.
Because commissions and trading costs occur whenever a fund manager buys or sells a stock, keeping the turnover below the average of 65 percent limits costs.