This article was posted on October 1, 1998.
The first thing you need to look at is your mutual fund prospectus. That's the 100 page document most people toss in the trash without reading. There are three pieces of information you need to glean from the prospectus; the annual expense ratio, the portfolio turnover, and the average brokerage commission. Since many fund managers are not proud of their turnover or the inflated brokerage commissions they pay, the last two items are frequently buried in a table entitled "other information."
What's an "investment expense?"
There are five types of investment costs that must be measured to determine your total investment expense:
The annual mutual fund expense ratio is prominently displayed in the prospectus. Depending on the fund, it ranges from a low of 0.03% to a high of 2% or more.
While "no-load" funds can be purchased commission free, sales loads on "load funds" can be as high as 8.5%. It makes little sense to buy a fund with a sales load because of the wide variety of no-load funds offering the same investment characteristics.
Trading costs really add up for a fund with high portfolio turnover. In Stocks for the Long Run, (Page 93) author Professor Jeremy Siegel estimates the bid/ask spread for stocks in the S&P 500 Index is 0.40%, while the spread on small cap stocks like the Russell 2000 average 2.65%. You need to multiply the cost of the bid/ask spread by the portfolio turnover to determine the trading cost for your fund.
Brokerage costs are surprising small. The average price per share on the New York Stock Exchange in 1997 was $43.34 per share. If your mutual fund pays an average 2 cents per share, the brokerage commission adds about 0.05% to the expense ratio if the fund has 100% turnover. You can use the following formula to estimate these costs
(turnover) * (average brokerage commission per share)/ ($43.34 per share)
Other costs like wrap accounts, annuities, or "financial advisors" can add up to 2% or more to your investment expenses
Low Expense Example
Buying a no-load mutual fund direct, without the use of a broker or "financial advisor", minimizes investment expenses. For example, the Vanguard S&P 500 Index Trust has an expense ratio of 0.17%, a 5% turnover, and an average brokerage commission of 1.8 cents per share.
High Expense Example
Your financial advisor charges a 1% of assets annual management fee. He recommends the purchase of the Kaufmann Fund for your portfolio. The Kaufmann Fund has an expense ratio of 1.89%, a 65% turnover, and an average brokerage commission of 7.0 cents per share. It invests in primarily in stocks represented in the Russell 2000.
Know what you're buying and what it costs
There are large differences in the fees and expenses associated with investment products. Make sure you know what you're buying, what fees and commissions are being charged, and if there is a low fee alternative to what's being offered. Reducing your investment expenses is a risk free way to increase your investment returns
The sites listed below allow you to search for low fee mutual funds:
Quicken.com Mutual Fund Finder
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Copyright © 1998 John P. Greaney, All rights reserved.