In a recent issue of Money Forever we looked at when it might be appropriate to consider ETFs as replacements for mutual funds. The reason being that most mutual funds, even “no-load” funds, are filled with high fees and expense ratios, and even hidden fees, spelled out in 4 point type, of course, while ETFs are generally pretty straight forward in terms of fee structure.

First we’ll look at a chart showing how even small fees can be costly over the long haul. Then we’ll consider whether it’s ever worthwhile to pay these pricey fees for top-performing mutual funds, and show you where to find the best alternatives. I sure hate paying fees, particularly when I’m not getting anything in return, and I bet you feel the same way.

A close friend has a bond mutual fund that returned 6% last year, net of fees. The fund effectively returned 7.38%, but fees totaled 1.38%, including a 0.65% management fee. While 1.38% might not sound like a lot, our friend basically paid 18.7% of his return (that’s 1.38% divided by 7.38%) in fees. Now that sounds like real money. And when you look at the compound effect he could be giving up tens of thousands of dollars.

How Big of a Difference Does a 0.65% Management Fee Make?

To show the effect of the fees, we graphed three lines. The black line shows the growth rate of a $500,000 portfolio at 7.38% per year without any fees. It’s easy to see the magic of compounding here. The gold line depicts the fund growing 7.38% each year, with the 1.38% expense fee subtracted each year. The green line portrays the same growth rate, but without the annual 0.65% management fee.

In just 10 years, the difference between the green line and the gold one is $59,703. A part of that difference is the fee itself, and another part is the lost opportunity cost; you can’t reinvest fees you have already paid out. In 20 years, the green line (without a management fee) reaches $1,783,000 – that’s $219,894 more than the gold line that includes the annual management fee.

While this scenario isn’t exactly the same as the choice between a mutual fund and a lower-fee ETF, the same principle applies. The average mutual fund fee is 0.79% (remember some are lower, but many are higher). In comparison to something like the Schwab US Dividend Equity Fund (SCHD) with a 0.07% fee, that’s a 0.72% difference – comparable to this 0.65% example.

But surely that 0.65% pays for top level investment management that outperforms the market, right? Let’s look at performance.

What About Paying for Performance?

You just saw how fees – even small fees – can dramatically add up over time. So why not just buy mutual funds that have historically performed well? Aren’t the fees worth it for performance?

To prove a point, we looked for the ten top-performing mutual funds of 2011 which we found in a Bloomberg article, Best and Worst Mutual Funds of 2011. We chose 2011 so we could test those funds with full year data for 2012, as if we were just starting the year fresh.

Then we asked a simple question. Suppose we were investors in January 2012 deciding to invest in these winners. How would our investments have performed up to the present?

The chart above graphs those ten mutual funds against the SPDR S&P 500 ETF Trust (SPY), an ETF that mirrors the S&P 500. The thick red line represents SPY. From these ten winners, only three have managed to outperform the S&P 500 since January 2012: ATRSX; PYSAX; and VLEOX.

If recent performance isn’t a good indicator of future performance, what is? If a fund has specific characteristics that appeal to your investment plans then consider choosing it. For example, if a mutual fund has the perfect combination of dividend stocks that you’ve been searching for, then go for it. For example, here’s something we ran across recently: a mutual fund that invests directly in African stocks. Even with an ETF, it’s hard to invest in Africa. This fund’s annual fee was highway robbery – something like 2.5% – but if you’re really looking for just Africa exposure, it still might be a decent choice.

If a certain mutual fund is exactly what you want and there doesn’t appear to be a cheaper alternative, then go for it. However, do not make your choice based on past performance alone. It is more often than not the case that you can find a suitable ETF alternative with very similar holdings and with a fraction of the fees.

We recently completed a new report dedicated to comparing mutual funds to ETFs, including the top 10 ETFs you should consider for replacing your expensive mutual funds. We’ve gone after some of the mutual funds most commonly held by individual investors and matched them up against lower fee ETFs with holdings that are nearly identical. To get this research, which could make a profound difference in your portfolio’s value, just click here.

Dennis Miller is the author of “Retirement Reboot”, a book chronicling his own journey to save his retirement in a low yield, turbulent investing environment and providing readers with actionable ideas for getting their retirement finances back on track. He works with some of the country’s top investment managers, authors and analysts to tackle the financial challenges faced by today’s retirees. Working with analysts at Casey Research, Dennis created "Miller’s Money Forever," a newsletter that provides retirees, and those soon to be retired, with actionable recommendations on how to prepare and maintain a profitable retirement portfolio. Prior to retiring in 2008 Dennis ran a successful consulting business and authored several books on sales management. He was also a regular contributor to the American Management Association and an active international lecturer for 40 years. Find more of Dennis’ columns and latest special research reports at millersmoney.com or contact him at dennis@millersmoney.

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