Articles

Are You Really Getting What You Pay For?

By Doug Roberts
AOL Contributor

I must admit that I was truly shocked when I read last fall about Securities and Exchange Commission probes into mutual fund firms for accepting kickbacks from the companies hired to provide services to them. The individual shareholder is the one who pays these fees to the service companies and should be receiving all of the benefits, not the mutual fund managers!

It reminded me of when I first started on Wall Street. I worked at an investment banking firm that was considered to be in the "Bulge Bracket" category, reserved for only an elite few and not known for discounting its fees. A mentor of mine let me know that the firm's policy on fees and expenses was simply, "First class business done in a first class manner for a first class price."

However, this gentleman also taught me to remember that we were working for the client, not the other way around. He said that in fee negotiations, "What is mine is mine, and what is yours is yours." It is not "What is mine is mine, and what is yours is half mine with the other half up for negotiation."

Somehow, I believe he would have felt many of today's mutual funds have crossed that line. This column will examine the various mutual fund fees and expenses from an investor point of view, to help you determine what you are paying and figure out if what you are getting back in return is worth it.

Understanding the fees There are two types of mutual fund fees and expenses -- the single shots and those that are ongoing. The single shots generally consist of one-time charges, like sales fees and redemption fees.

Sales fees or commissions, often referred to as a "sales load," may be charged when you enter the fund (front-end) and when you exit it (back-end). They are usually paid to the mutual fund company, the broker or salesman.

I strongly urge you to avoid investing in funds that charge a sales commission. When a sales commission is charged, possibly 4% to 5%, this means that you must outperform a similar fund without a commission by that amount just to match its performance. This is usually not an easy task. Furthermore, a sales load locks you into the fund. You need to stay in it for a long time to cover this cost and still get a competitive rate of return. When a commission is charged, you never know if your broker or advisor is favoring the fund that is best for you, or the one he stands to profit from the most. Often, if you do some detective work, you can find a similar fund without the commission, sometimes with the same manager.

Redemption fees usually refer to fees charged for early redemption in order to discourage short-term trading and "market timing." These fees are not bad for the long-term investor, as long as they are reinvested into the fund and not pocketed by the fund managers, brokers or salesmen.

With redemption fees, the key is to ensure that the fee is paid to the mutual fund itself. In general, I prefer funds that do not extend their redemption fees longer than three to six months, unless they offer superior performance for their category with a very low expense ratio.

In addition to these one-time charges, there are ongoing fees that are charged every year and impact the performance of the fund, even for the long-term investor. These include the expense ratio and brokerage costs.

The expense ratio is the total annual expenses of the fund, expressed as a percent of assets in the fund. It includes the management fee paid to the mutual fund manager, operating and administrative fees paid to run the fund, and 12b-1 fees used to market and distribute the fund. The general rule with expense ratios is "The lower the better." New funds sometimes have high expense ratios because of their small size. These funds should make every attempt to lower the expense ratio as they grow. This indicates a cost-conscious environment and a desire to put shareholders first.

The brokerage costs are the costs of the fund in buying and selling securities. Often, this information is not readily available and can be found only in the prospectus.

There are sometimes other fees and expenses associated with mutual funds. However, those outlined above are the main ones to be aware of.

The case for index funds I favor index funds for several reasons. Academic research, as well as my own data, has shown that the choice of the stock category (large, mid-cap, small, growth or value) is more important than the actual stocks themselves. It's analogous to buying a home, "It's not the house; it's the neighborhood." My research has also shown that it is incredibly difficult for an actively managed equity fund to beat the S&P 500 over an extended period of time, and even more difficult to beat the category benchmark. A well-operated equity index fund can have an extremely low expense ratio, as little as 0.18% as compared to 1% or more for an actively managed fund.

In addition, exchange traded funds (ETFs), which are similar to index mutual funds, are now proliferating in every shape and flavor. They can also be more tax-efficient for the long-term investor. You hear their names all the time: Diamonds (Dow Jones Industrial Average), Spyders (S&P 500), and the Qs (NASDAQ 100).

Remember to carefully check the fees and expenses of any mutual fund you are considering. Avoid buying mutual funds that charge a sales commission. And try index funds and ETFs, where you actually get what you pay for.

Doug Roberts is the Founder and Chief Investment Strategist for FollowtheFed.com, an independent research firm focusing on investment strategies using the Federal Reserve's impact on the stock prices. He previously held executive positions at Morgan Stanley Group and Sanford C. Bernstein & Co.

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