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|
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%|
|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%.
Return to the Main Menu.
Scoring Fund Cost and Expense Data
Financial AdvisorDespite trends indicating an overall decrease in fees across many fund categories, investors should still pay attention to expense ratios: even small differences in fees can have a significant ...
InvestingLearn about the basics of trading and investing in mutual funds. Understand how the fees charged by mutual funds can impact the performance of an investment.
InvestingMutual funds are a good way to balance your asset allocation but there some potentially expensive pitfalls investors need to be aware of.
Financial AdvisorDiscover some of the basic characteristics shared by good mutual funds that investors can use to help them in selecting funds.
InvestingDiscover how investment strategies and expense ratios impact your mutual fund's returns.
Financial AdvisorWhat to really look for when you're deciding on a mutual fund.
InvestingLearn about considerations for investors when buying shares in a mutual fund for a long-term investment, including fees, type of management and portfolio goals.
InvestingLearn how to evaluate mutual funds and find the right one for you.
InvestingFind out how no-load funds, index mutual funds and ETFs can help investors boost returns just by cutting down on expenses and sales charges.
Financial AdvisorMore than 80 million people, or half of the households in America, invest in mutual funds. No matter what type of investor you are, there is bound to be a mutual fund that fits your style.