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Mutual funds are a great investment tool for people saving for retirement, education and many other goals. According to the Investment Company Institute, over 60% of households invest in mutual funds for their retirement, and about 50% of all households hold some mutual funds. But how do people choose them, and are they getting what they pay for?
When shopping for funds, we have access to more funds than we could possibly consider carefully. There are about 8,000 mutual funds to choose from and most people don’t have any formal training on what factors to consider when selecting funds. Most people don’t have the time or expertise required to make sense of the seemingly infinite amount of information that is available about mutual funds. So how do people choose them?
The power and danger of prices
For a lot of purchases we make, we understand what we are buying, we know our preferences and can compare prices vs. perceived benefits to make informed decisions. For example, you can buy some laptops with and without a touch screen, at different prices. It’s not hard to make the right decision if you know how you are going to use the laptop. But, when we don’t fully understand our preferences or what we are buying, prices become an imperfect signal, and our choices can be suboptimal as a result. How do you pick a good bottle of wine for a party when you don’t know much about wines? You probably end up choosing an expensive one.
Using prices to anchor our preferences can make us susceptible to deceptive advertising, as Dan Ariely shows with some interesting examples in this video. When choosing mutual funds, our lack of understanding can make us more likely to pay higher prices for a fund company whose name we recognize, or pay higher fees for a fund with appealing keywords in it, like “growth”, “dynamic”, “quality,” or for funds that have had higher recent performance. Who does not want all that? But, are more expensive funds better for you than other low-cost options?
Do more expensive funds perform better?
We have talked before about the difficulty of predicting winners and losers based on past performance or market cycles. Research shows that if there is one predictor of future performance, it’s fees. The direction, however, is not what you may think, as research by Morningstar shows. Funds with higher fees had lower average returns over the period considered (2011-2015), as shown below for mutual funds that invest in US stocks.
When funds are grouped into quintiles from the least expensive to the most expensive, the ones with the lowest fees had the highest returns. Fees vary greatly by funds. The average cost across funds in the first quintile is 0.65% in the study, and the average cost in the fifth quintile is 2.20%. The cost of owning the funds is measured by the so-called expense ratio, which every mutual fund reports and we discuss below. The good news is that because higher costs don’t result in greater benefits for investors, investors can focus on low cost, first-quintile funds when selecting mutual funds. This pattern is not only observed in US stock funds, but also in funds that invest in international stocks and bonds. When selecting mutual funds, diversification and low fees are two great principles to start with. If instead, you are considering a fund with a higher expense ratio, make sure it offers other tangible benefits for your goals, and ask for reliable evidence of the benefits.
What fees do mutual funds charge?
Mutual funds can charge a number of fees to investors. Here are the most common ones.
Operating expenses and expense ratio These typically include management fees (the cost to pay the fund’s managers) and other operational costs (legal, accounting, and other admin costs). They can also include so-called 12b-1 fees, which are fees that can be incurred to sell the fund. All these fees are usually expressed as a percentage of the fund’s assets, and together form the expense ratios. If a fund’s net expense ratio is 0.50%, it basically means that it costs $5 for every $1,000 invested, per year. As your investment grows over time, so does your dollar cost.
Front-end load These are sales charges deducted from the initial investment, typically to pay for broker commissions on the sale of the fund.
Back-end load or redemption charge Similar to front-end load fees but are charged when you withdraw from a fund. They are typically reduced over time.
There may be other, less common fees, like short-term trading fees, account maintenance fees, etc.
How should you choose?
If two funds have different fee structures, you should compare the expected cost of investing in each of the funds, accounting for all of the expenses, per year. However, in practice, you can avoid funds with sales loads. Why pay for a commission when you don’t have to? You are better off spending the money you save by hiring an independent, fee-only advisor that can give you objective advice instead of a broker.
Low fees
Should you choose the funds with the lowest expense ratio? Not necessarily, but low costs can help, as the chart above shows. Typically, funds with lower expense ratios are passive funds that track an index. Expense ratios among stock index funds averaged 0.63% in 2018 (equal-weighted), according to a Morningstar report, and some can be below 0.10%. Among actively traded funds, those that attempt to beat index returns by picking companies or timing market cycles, the average expense ratio was 1.11%. This helps us interpret the chart above. Actively traded funds fail to beat index returns despite the higher fees, which is similar to evidence that we have reviewed before.
Low turnover
The expense ratio is certainly one important metric to look at, although certainly not the only one. Another aspect that helps explain the low performance of high-cost funds is that typically those funds have a higher turnover. High-cost funds tend to trade a lot more frequently than less expensive, passive funds, and trading is costly. High turnover across active funds contributes to their relative underperformance. So consider turnover, which is typically reported in a fund’s annual report, when choosing a fund.
Diversification
Some of the funds with the highest fees are also the least diversified. For example, while the US stock market lists about 4,000 stocks, the median number of holdings across US actively managed funds is only about 80 stocks. Globally, there are over 12,000 stocks, so a globally diversified fund should hold thousands of stocks. By choosing a fund with only a few stocks you place a bet on the ability of a manager to outperform the market, which we know is very rare.
To summarize, start by leaning towards low-cost, low turnover, highly diversified funds. An expense ratio of 0.65% or below and a turnover below 25-30% should give you plenty of good options to choose from. Keep in mind that expense ratios tend to be a bit higher for small-cap funds and international funds. Index funds, those that track commercial market indices like the S&P 500 are good options to start with. But pure index funds can have other costs that are not captured in expense ratios, so talk to us or stay tuned to learn more in future posts!
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
