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Are you getting the shaft in your mutual fund?

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Are you getting the shaft in your mutual fund?


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News Flash (11/14/97): You're also getting the shaft in your 401k. Click here for details.

Just about everyone has a large portion of their retirement assets in one or more mutual funds. The growth of mutual funds over the past ten years is probably the number one reason that more than 50% of all American families own stock today.

Why are mutual fund expenses so high?

Unfortunately, not all the news is good. While assets under management have exploded beyond all imagination, so have the fees being charged by your mutual fund manager. Investors in just about any other arena typically benefit from what economists call "economies of scale." In a given situation, you would expect a $10 million company to have lower overheads as a percent of assets than a $1 million company. This is especially true for an operation that lends itself to automation - such as a mutual fund. Over the past decade, many mutual funds have grown by a factor of 10 or more. Yet the fees charged by the managers have actually risen as a percent of assets. If a fund with $1 billion in assets had a 1% management fee, reasonable economies of scale would suggest that when it had grown to $10 billion in assets the management fee would be no more than 0.30% of assets. Few fund managers have allowed these economies of scale to accrue to their shareholders.

What's the story on "soft dollars"? Is it really the scandal it appears to be?

So called "soft dollars" are essentially kickbacks that mutual fund managers receive from the stock brokers that clear their trades. It works like this. Let's say that you or I would pay a commission of 2 or 3 cents per share on a 1,000 share trade. If we were trading blocks of 10,000 shares, we'd expect the economies of scale to earn us an even lower commission. Say, 1 and 1/2 to 2 cents per share.

Reports are that the Securities and Exchange Commission will allow a mutual fund manager to pay a broker an inflated commission of say 6 cents per share for a 10,000 share trade and then enter into a side agreement for the broker to rebate 4 cents per share of "soft dollar" goods and services. Some examples of these goods and services are listed below:

  • Research reports.
  • Paid travel and expenses for "seminars" in Hawaii.
  • Notebook computers for the mutual fund manager.
  • Paid travel and expenses for "seminars" in the Caribbean.
  • Pay the mutual fund manager's office rent.
  • Paid travel and expenses for "seminars" in Aspen.
  • Pay for the mutual fund manager's magazine subscriptions.
  • Paid travel and expenses for "seminars" in Europe.
  • Pay for the mutual fund manager's phone bill.
  • And last but not least, pay the wedding expenses for the fund manager's daughter. (Yes, this actually happened according to Barry Barbash, the SEC's director for the division of investment management.)

If you're an employee of almost any Fortune 500 corporation company rules most likely prohibit you from taking anything of value from a vendor. Yet, your mutual fund manager is allowed to operate in a manner that would shame a Congressman.

What can investors do to protect themselves?

Paying close attention to fees and expenses is the best protection investors have. While it's probably too much to ask that people read a mutual fund prospectus from cover to cover. There are three items that you should check: 1) the expense ratio as a percent of assets, 2) portfolio turnover, and 3) the average brokerage commission per share.

Expense Ratio

The mutual fund industry has been quite inventive in devising ways to skim money off their investors. In addition to the management fee, other fees like the sales load, redemption fees, and 12b-1 fees can be levied on shareholders. You need both an MBA and a law degree to keep up with all the permutations. Luckily, there is a way to cut to the chase and quickly determine the depth of your wound. One of the few truly public spirited reporting requirements mandated by the SEC is the following table illustrating the expenses you would incur on a $1,000 investment over various periods, assuming (1) a 5% annual rate of return and (2) redemption at the end of each period. The expenses are calculated for 1, 3, 5, and 10 years. Every mutual fund prospectus contains this table and uses the same assumptions, so it's easy to compare one fund with another. For example, a fund with a 1% management fee and no other charges would look like this:

Cumulative

1 Year3 Years 5 Years10 Years
$11$33 $58$132

As a rough guide to what you should be looking for, Retire Early has put together a recommendation for the maximum fees you should be willing to pay for several types of mutual funds. These recommendations should get you a fund with expenses in the bottom 10% of funds of that type. In other words, 90% of investors will be paying more than our recommended expense level. Somebody has to pay more, it just shouldn't be you.

Money Market Fund - pay no more than 0.40% of assets in fees and commissions.

Cumulative

1 Year3 Years 5 Years10 Years
$4$13 $23$53

Bond Fund - pay no more than 0.30% of assets in fees and commissions.

Cumulative

1 Year3 Years 5 Years10 Years
$3$10 $17$40

S&P 500 Index Fund - pay no more than 0.20% of assets in fees and commissions.

Cumulative

1 Year3 Years 5 Years10 Years
$2$7 $12$26

Large Company Stock Fund - pay no more than 0.60% of assets in fees and commissions.

Cumulative

1 Year3 Years 5 Years10 Years
$6$20 $35$79

Small Company Stock Fund - pay no more than 0.75% of assets in fees and commissions.

Cumulative

1 Year3 Years 5 Years10 Years
$8$25 $44$99

International Stock Fund - pay no more than 1.00% of assets in fees and commissions.

Cumulative

1 Year3 Years 5 Years10 Years
$11$33 $58$132

Portfolio Turnover

Portfolio turnover is a measure of how often your mutual fund manager buys and sells the stocks and bonds in the fund. While we're all taught to work hard and do as much as we can, the same traits in your mutual fund manager can cost you a lot of money. Each trade costs you more than the brokerage commission. There's the matter of the spread (that's the difference between the bid and ask price) and the fact that you might have to pay taxes on any gain. A hyperactive fund manager is unlikely to be a help if maximizing your net worth is your goal.

For more on portfolio turnover, see the U.S. News and World Report's article, "Is your fund running you?" It's an excellent analysis on the perils of actively traded mutual funds.

Retire Early recommends that you buy funds with portfolio turnovers of less than 25%. Index funds should be have portfolio turnovers of less than 5%. Remember, you're looking for a fund manager that makes the right decision the first time and lets his winners ride. "No sense sellin' just to be sellin'" is a useful rule to follow.

Average Brokerage Commission

We've already addressed the possible abuses with brokerage commissions. Anything more than 4 cents a share may be an indication of a "soft dollar" problem.


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Copyright 1998 John P. Greaney, All rights reserved.

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