Zeroing In On Mutual Fund Expenses

Mar 5, 2024 | Budget

Four people walk with bicycles along a beach. Text on the left reads: "Zeroing In On Mutual Fund Expenses," highlighting the importance of cost-effective investing, accompanied by the logo for Stewardship Trust Advisors.

Zeroing In On Mutual Fund Expenses. Investment options continue to expand and competition for investment dollars increases. In light of this, the mutual fund industry is coming under increasing scrutiny for the expenses charged in many mutual funds. With the advent of no-load mutual funds, index funds, and exchange-traded funds, many investors are questioning the reasonableness of expenses charged by many of the industry’s more popular funds. In times of double-digit market gains, as have been experienced in recent years, mutual fund expenses are less of an issue. However, as market volatility increases and investors pare back their expectations, expenses, and their effect on total returns, it suddenly become a bigger issue.

Weighing the Factors

There are literally thousands of mutual funds to choose from. In light of this, it becomes much more important to weigh all factors when comparing fund choices. Investors have always looked at fund performance as a primary point of comparison. But, as they have learned, often the hard way, the past performance of a mutual fund is no indication of how it will perform in the future. Few funds can consistently outperform the stock market indexes. And fewer funds have demonstrated any capacity to repeat earlier top performances. But, there is one constant among all mutual funds that can be measured, weighed, and compared. That is expenses. Specifically, the fund’s expense ratio – which is a measure of the fund’s operating costs. Higher operating costs will result in a reduction in the fund’s return on investment.

Mutual fund salespeople have long argued that funds with higher sales loads or expenses outperform no-load or low-expense funds. However, that is not necessarily the case. In fact, studies have shown that, collectively, index funds with lower expense ratios generate more consistent returns. They also tend to outperform more expensive funds over time.

This is not to suggest that you shouldn’t consider expensive funds. But, it does suggest that the expense ratio is a critical factor when it comes to long-term fund performance. However, in general, index funds, which typically have much lower expenses than actively managed funds, perform much better during a bull market. And actively managed funds generally perform better in a bearish market.

Understanding Expense Ratios

Morningstar and other investment sites have done much of the work for you in breaking out the expenses and expense ratios of the thousands of mutual funds it analyzes. What’s more, they provide for easy, direct comparisons with other funds in related investment categories. This means you’ll be comparing funds with similar objectives and management styles.

This comparison format is extremely useful for narrowing down your choices. However, there are other factors not included in the expense ratio. These weigh heavily on the overall investment cost and long-term performance of the fund. For instance, the portfolio turnover rate. This is the rate at which the investment managers buy and sell stocks. And it can increase the investment costs if the rate is high. When stocks are sold frequently to capture short-term gains, the portfolio is taxed on the gains. That cost is then passed on to you in the form of reduced returns.

Additionally, the expense ratios don’t reflect other costs, such as fund redemption fees or sales charges. Not all funds include these charges. But where they exist, they are paid directly by the investor, so they aren’t included in the expense ratios.

Load vs. No-Load

With so many fund choices, investors may not have to consider funds that charge sales loads (commissions) or 12b-1 fees (annual sales fees). But, it’s not always wise to step over a dollar just to save a dime. No-load funds may seem like the better choice. However, it’s important to carefully examine the investment management fees.

Some fund companies will try to make their funds more attractive by eliminating the sales load. But on the other side, they will then recoup the lost revenue by increasing other fees. Just a half-point increase in the annual management fee could extend the expense break-even point of the fund out several years.

A load fund with very low management fees or expense ratio could very well achieve a break-even point much sooner. The problem is that the fund analysis available through sites like Morningstar doesn’t factor in sales loads. This means that you may have to calculate the true break-even point on your own. It is also important to note that many load funds enable IRA investors to buy shares typically available only to institutional investors. These shares can oftentimes be purchased without a sales load and with lower minimum investment requirements. As a Fee-only RIA firm held to the “Fiduciary Standard”, all funds Pilgrims Capital Advisors, Inc. purchases for our clients are no-load or an institutional class of share with the lowest management fee available and without sales charges.

Expenses are Only a Part of the Story

Expense ratios should always be considered when selecting mutual funds for your long-term investment portfolio. But, it’s important not to ignore other key factors that will help you determine how closely a mutual fund matches your investment profile, including your risk tolerance. Measures such as the Sharpe Ratio or the Alpha Ratio are key indicators of a fund’s relative volatility and its risk versus the stock indexes. And in the long run, this can be far more important than the expense ratio.

Call Stewardship Trust Advisors

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These weekly articles which are produced and distributed by Pilgrims Capital Advisors, Inc. contain information on topics about investing, tax planning, estate planning, asset allocation, insurance, and many other financial subjects. Please note that they are very general and must be applied to your circumstances through the services of a trained or licensed professional who specializes in these areas. If you have questions or needs related to the subject matter of this article please contact us by clicking on the link below and we will point you in the right direction.

Pilgrims Capital Advisors, Inc. is a Registered Investment Advisory Firm located in the state of Michigan.


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