Published April 21. 2013 4:00AM
Are your mutual funds worth what you are paying to own them?
Most investors answer that crucial question backwards, saying that the fund's results either do or do not justify the money the percentage that management keeps for itself.
The problem is that investors should answer that question looking forward, trying to come up with reasons why they believe the manager can justify their paycheck.
What makes that hard to do is that most investors don't have a good idea of what is reasonable to pay for a mutual fund.
The Investment Company Institute, the fund industry's trade association, came out this week with its annual look at fund expenses, crowing about how the trend in recent years has been going in the right direction.
Indeed, while fund ownership, on average, costs less than in the past - and while the statistics show that investors tend to concentrate on issues with low costs - few fund buyers properly factor costs into the buying equation.
Costs matter because they are the one thing that an investor can count on; returns, by comparison, will vary, but management takes its cut regardless. So if a large-cap growth fund is up 8 percent in a year and charges the average expense ratio for the category - 1.27 percent, according to Morningstar Inc. - the fund is going to be up 6.73 percent for the year, the gross return for the fund minus its cost.
Money, however, typically flows into lower-cost funds. The "dollar-weighted average" expense ratio for large-cap growth funds - the average paid by investors who own funds in the category - is 0.80 percent, according to Morningstar. That means that if the fund can generate a gross return of 8 percent, their return from the fund will be 7.2 percent.
That difference adds up over time. If the market averaged that return each year over 10 years, the investor in the fund with the lower expense ratio would double their money, while the one facing higher costs will come up about 5 percent short of that.
That's why some investors are so adamant about owning low-cost funds that they let the means - the ongoing costs - justify the ends, namely whatever the fund delivers.
But low costs simply mean that shareholders will keep more of what the fund earns in the marketplace; they don't guarantee great returns.
And that's why another sub-set of investors expects the ends to justify the means, ignoring costs with the expectation of superior returns. Indeed, you could argue that kind of thinking is what drives the hedge-fund world, where the standard fee is 2 percent, plus 20 percent of the profits, a lot higher than the average mutual fund, but where investors are expecting higher returns than they could get in traditional vehicles.
Part of the problem is that while average expense ratios are going down, most investors don't know where to put that line that determines if a fund's costs are high or low.
According to Morningstar Inc., the average stock fund, regardless of type, charges 1.36 percent for expenses, while the average bond fund prices out at 0.99 percent. The dollar-weighted averages, which show what the typical investor is actually paying, are 0.76 percent for equity funds and 0.61 percent in bond funds.
Depending on the assets the fund buys - and some of the techniques/difficulties involved in trading those securities - the average costs range from 0.75 percent for near-term (2011-2015) target-date funds to 2.53 percent for managed futures funds.
The real question, regardless of the asset category, however, is "Do I expect this fund to deliver returns superior to an appropriate index fund?"
"The question shouldn't be 'What's the expense?' so much as 'What are the reasonable expectations for the fund beyond its benchmark,'" said David Trainer, president of New Constructs Inc., a Nashville-based stock and fund research firm. "If the incremental expense above and beyond what you would pay for the index is not justified by the returns you expect the fund to deliver, then it's not worth paying up for the fund.
"And if you think the fund can deliver the extra return but, going forward, it doesn't, you have good reason to be disappointed with the fund."
There are reasons to "pay up" for a fund; perhaps you like a manager of a small start-up fund, where the issue has yet to garner enough assets to cut costs. Or maybe you want to pursue a more esoteric investment strategy.
The average long-short equity fund, for example, carries an expense ratio of 2.04 percent; the average investor in those funds is paying 1.29 percent, which means they are gravitating toward cheaper options but they are still paying more than if they used a more-conventional fund type.
Even in something as common as small-cap growth - where the average fund charges 1.47 percent, and the typical investor is paying 0.98 percent.
By knowing the average expense ratio, and what the typical investor pays, you can decide whether you really believe the fund's potential is worth any premium you might be paying.
Said Trainer: "A fund that charges more than average has to be able to convince you it's worth it, and it has to do that before you buy it. It doesn't make a difference that expense ratios are coming down, if you're not getting what you are paying for from your funds."