Investing in mutual funds is a wonderful way to grow your investments, but all the fees associated with such investments them can be a financial drain. Learning about these expenses and how to reduce or eliminate them is a relatively easy way to increase your returns. Taking the time to mark smart decisions and plan out your retirement investments will relieve a great deal of stress later.
Diversify with mutual funds
Mutual funds are essentially broad collections of stocks, bonds, and/or other securities that you can buy into as a pool. Buying individual stocks instead of a diversified mutual fund can cost quite a bit of money, and also exposes you to risks associated with poor diversification. Thus, many people include mutual funds in their retirement portfolio.
There are a tremendous number of mutual funds out there, each with different investing goals and styles. Index funds are an increasingly popular type of mutual fund because they invest in whole sectors or markets, and can provide an broad diversification while minimizing costs. This broad diversification reduces specific (or “unsystematic”) risk associated with individual securities. Diversity is good because it can reduce risk by not having all your investment eggs in one basket.
While mutual funds can be an economical way of investing, you still have to keep your eye on the fees.
Mutual fund loads
Loaded mutual funds are simply mutual funds with an extra sales cost added. This fee can be tacked on at the initial sale (front-end load) or when you liquidate (back-end load). Mutual fund loads are basically a sales commission, and typically run around 4-6%.
Do they offer a real benefit for you as an investor? I would say the answer is no, as there’s no good evidence that funds with sales loads outperform those without. If you invest $10, 000 for a front load mutual fund, $500 would be taken for the commission, leaving $9, 500 to invest. That might not sound like much, but as compound interest grows through the decades, you’ll have a lot of ground to make up.
I should also mention that some mutual funds with back loads can include a contingent deferred sales load. In other words, if an investor holds the fund for a certain amount of years, the commission decreases to 0%. If you’re a buy and hold type of investor, this can make a big difference, though I would still shy away from any fund with an associated sales load.
Over at Fool.com, I ran across some candid remarks on load funds and no-load funds:
…there is no real difference historically between the performance of load funds and no-load funds in terms of year-to-year performance. In fact, according to the latest survey by the mutual fund data analyzer Morningstar, even excluding the drag on returns if the load were included in the calculation, no-load funds actually have a superior record to load funds over the last 3-year and 5-year periods.
The bottom line is that, if you’re looking to invest in mutual funds, you should look for funds with no sales commission tacked on. There may, however, be other fees associated with it, so don’t let your guard down.
Yahoo! Finance has a mutual fund screener that can help you find some good no-load mutual funds relatively quickly. There are also a number of well known mutual fund families that offer no-load mutual funds. A few of my favorite sources are:
Expense ratios
In order to pay for the marketing and management costs of a mutual fund, you will also be charged an expense ratio. An expense ratio is usually calculated as a small percentage of your holdings. In general, you’re looking for the lowest expense ratio possible for a given fund type. In many cases, index mutual funds offer both low expense ratios and historically solid returns. A big reason for this two-fold benefit is that index funds do not require a management team to decide where to invest your money. Instead, your fund simply tracks a broad market index. This sort of automation results in cost savings that are (hopefully) passed on to you.
Your thoughts
While there are certain unavoidable costs associated with investing, many of these costs can be avoided, or at least minimized. You may have to do a bit of legwork to learn about your options, but the benefits are big. In general, I would pass on on expensive (and often loaded) mutual funds in favor of low-cost index funds.
How about you? What sorts of investments are in your portfolio?
Vanguard Total Stock Market Index, mostly. I’ve been dabbling in Prosper, but think of it more as an interesting gamble/donation than a real investment tool.
@Nickel – most advisors (not the salespeople that claim to be advisors) do a lot more work for their clients than simply sitting on an investment made several years ago. Many offer assistance in putting together a retirement plan, estate planning advice, etc. The ongoing fee (usually 0.25%) can be a relatively small price to pay for these services, and having someone to call when the sky seems like it’s falling can be worth considerably more.
Also, I’ve always believed that investors are best served by having an advisor for a period of time that can teach them how to invest and to help them question their impulses. This process is something that is difficult to duplicate through other avenues like books, periodicals, or the internet, and advisors are usually happy to have clients that actually get involved in the investment selection process.
Finally, when it comes to fee versus commission, I definitely prefer fee based advice on an hourly rate as opposed to percentages. That said, most investors cannot afford to pay $150 to $250/hour for advice (Robert Shiller advocates a tax credit to help consumers get better advice). Even advisory platforms for the masses like Smart401k.com charge more than $200 to setup portfolio allocations. For most investors, particularly those starting out, paying through a commission/load is a lower cost alternative. If I have $2,000 to start investing, will I pay $200 for an hour of service? Or will I pay a sales load of $100 and be able to call whenever I like? Or will I try to pick something on my own and hope that it works out? Also, good advisors can point out other weaknesses in an individual’s financial condition and may tell a new investor not to invest at all and to put it away in an emergency fund or buy life insurance or put it towards debt. If you like, here’s a more thorough view of what I think about advisors – good and bad – http://bit.ly/9FPvzE
There is a major gap in the delivery of advisory services, and each person needs to find what works for them. I simply cannot accept that a load is always a bad thing. For millions of people, it works just fine. As always, however, investors must regularly evaluate the cost-benefit relationship of the fees they are paying – whether the explicit cost of a sales load or the imputed costs of investing on one’s own.
@Laura – AGTHX, AIVSX, AEPGX, ABNDX, CWBFX, SMCWX, AMUSX. Just about anyone can build a well diversified portfolio out of these 7 funds. If you take the time to plug this into Principia/X-ray/AdvisorWorkstation/Whatever Morningstar product you want, you will find that (over the long run) any diversified portfolio using these funds delivers above average returns with below average risk and has a below average expense ratio including the sales load (which can be reduced based on the size of the investment).
On the question of load versus index, the same case can be made for actively managed funds versus the index. If you take the strong view of the efficient market hypothesis, then you will never own an actively managed fund or attempt to buy individual securities (save for a bond ladder through Treasury). Thus, if you are looking at active funds, we can only assume that you don’t believe in EMH and then we get into a discussion of styles and cycles – a discussion for another time perhaps.
Are you using 5-year returns to measure performance? Maybe for a fund that has a manager at the helm for only 5 short years, but one of the most compelling aspects of American Funds is their long manager tenure that adds more validity to their long-term return numbers. Many of their managers have been there for decades and I think the last time they lost a fund manager to a competing company was in the 1980s.
At any rate, I like the main thrust of the article, but indiscriminately throwing load funds under the bus simply isn’t a balanced assessment of investing.
Thanks Micheal for asking. I think paying for good, solid advice is fine. If you can find it cheaper or better,though, I think you go for it.
I’ve read a while back that index funds have consistently done better than loaded funds for about 80% of the time. When I checked American Funds today, many of their funds’ 5 year returns were a bit lower than the S&P 500. A few have done alright with some good returns, but they were the exception.
If you picked the good ones Michael, continuing doing it!
I think diversifying your investments is huge and believe that using mutual funds to do so is promising. Being able to do it at a low cost is even better. Yeah, you can possibly purchase the VanGuard funds or the funds at T. Rowe price without sales commissions, but you will still have the other fees. Last week, I read in Kiplingers about a new company called InvestForLess. You can invest in the institutional share classes of mutual funds without the sales charges, commissions or other fees. They are currently working out a new relationship for a custodian, but it looks pretty promising. The site is investforless.com.
Michael: Playing the Devil’s advocate here, why should I pay for that advice on an ongoing basis? Once I’ve decided to invest in a fund, I get nothing further by continually paying a load on all future investments. All else being equal, I’d much prefer go to pay for my advice on an a la carte basis with a fee-only advisor.
@Laura – I have a bit of a beef with your article as it carries a slant against load mutual funds without any discussion of what the load pays for – namely, advice. For investors that do not need or want advice from an investment advisor, you’re right, load funds are simply dollars wasted. However, for the millions of investors who want advice and are willing to pay a fee for it, load funds work.
Also, I’d take American Funds’ lineup against any mutual fund company as they’d stack up just fine on a cost, risk, and return comparison – even after the sales charges.
My retirement stuff is in the no-load funds and lowest-cost index funds, though there are some unavoidable fees through the management company my employer chose (these are more than offset by the company match on savings).
My non-retirment stuff is a little bit of direct buys through an online broker we chose for cost reasons, and a smattering of single-picks my mom gave us.
She hasn’t paid a broker in years, she quit her broker back in the ’80s and buys through DRIPS, diversifies through splits. But she pays a lot of attention to the market – i’ll spend mad money on a single pick but I don’t want to do it for a hobby, so i’m sticking with the index/mutual fund stuff for retirement.
I never, ever buy loaded funds. I mainly stick with index based ETFs built around a balanced asset allocation model that is a mixture of domestic, international and emerging markets large-cap, small-cap, value, REITS and bonds. Not too crazy about a lot of the bond index funds due to their market-cap approach (i.e., the biggest debtors are the largest holdings), so have some retail bond funds, but try to keep their expenses below .5%.