By Richard Loth (Contact | Biography)

One of the most important criteria for finding investment quality in a mutual fund is the indisputable fact that low-cost funds outperform high-cost funds. It is that simple. In terms of putting this concept into practice, mutual fund investors should:

1. Avoid funds with sales charges (loads) and 12b-1 fees. Choose funds with rock-bottom expense ratios.
Besides adding to your initial cost of investing, investing in a fund with a load incurs a "hidden fee." To illustrate how this happens, let's compare two fund investments. The XYZ Fund and the ABC Fund are similar in all respects with the exception that XYZ has an up-front sales charge of 5.75% and ABC is no load. The assumed annual total return for both funds is a steady 8% on the amount invested.

Deducting the 5.75% load ($575) from the initial investment of $10,000 in XYZ leaves $9,425 to compound at an 8% rate. With the ABC no-load fund, the full $10,000 compounds at the same rate.
The difference in compounded total returns between the XYZ Fund and the ABC Fund for the indicated time periods are $1,241, $2,680 and $5,786, all in favor of ABC. Looked at another way, the investment in XYZ, because of the lower discounted initial investment amount ($9,425), cost that investor a "hidden fee" equal to the difference of the compounded total returns.

Equating fund investment quality with a low expense ratio is a well established conclusion of a number of investment research studies. According to the Boston-based Financial Research Corporation (FRC), not only is the expense ratio the best predictor of performance, it is the only statistically reliable predictor. In July 2005, MarketWatch's Paul Farrell reported on a then recently completed FRC study:

Details ABC Fund XYZ Fund Differential
Funds to Invest $10,000 $10,000 -0
Minus Load -0 $575 $575
Actual Investment $10,000 $9,425 $575
Compounded Return
10-year $21,589 $20,348 $1,241
20-year $46,610 $43,930 $2,680
30-year $100,627 $94,841 $5,786

The FRC tested 11 popular criteria investors use to pick funds: Morningstar ratings, past performance, turnover ratios, asset size, expense ratios, manager tenure and net sales, plus four risk/volatility measures - standard deviation, alpha, beta and the Sharpe ratio. FRC's research suggested that the expense ratio was the most reliable predictor.

According to FRC, funds with low operating costs deliver above-average future performance across nearly all time periods. Other criteria proved to be statistically unreliable predictors - including Morningstar's popular star ratings and the Sharpe ratio, which calculates risk-reward variables for investments. (To learn more, read The Sharpe Ratio Can Oversimplify Risk.)

2. When it comes to mutual fund costs and expenses, a mutual fund's investment quality increases with the absence of sales charges and 12b-1 fees and the presence of low expense and portfolio turnover ratios. Low-cost funds outperform high-cost funds.
To help readers get a quantitative fix on expense ratios, let's look at some averages by broad fund categories as per Morningstar's FundInvestor year-end 2005 fund statistics for its universe of 500 of the most widely traded mutual funds:

Large Cap Stock 1.35% to 1.53%
Mid Cap Stock 1.47% to 1.62%
Small Cap Stock 1.50% to 1.71%
Allocation Funds 1.49%
Foreign Stock 1.71%
Emerging Market Stock 1.98%
High Quality Bond 1.02%
High Yield Bond 1.27%

Most top-rated domestic stock funds are going to have expense ratios around the 1% mark. Those of low-cost fund companies will be at or below 0.75%.

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Table of Contents
  1. Overview Of Mutual Fund Expenses
  2. Fund I-Q No.6: Costs and Expenses
  3. Scoring Fund Cost and Expense Data


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