May 31 2010

Say “No” to Mutual Funds with High Fees

Posted by Simon Zhen in Investing
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This is a guest post by Mariusz Skonieczny, founder and president of Classic Value Investors, LLC, an investment management company. He is also the author of Why Are We So Clueless about the Stock Market?, a book on the fundamentals of stock investing.

Did you know that there are more mutual funds than there are stocks? Have you ever wondered why mutual funds are such popular investment vehicles?

Conventional wisdom will tell you that mutual funds are popular because:

they do not carry hefty commissions.
they allow the little guy to invest in the markets because the start-up capital can be small.
they offer diversification because they hold many investment positions.
they are managed by professional money managers.

Unfortunately, these are the reasons given to investors, but the truth is that mutual funds are popular because mutual funds are extremely profitable to the investment industry.

High Costs of Mutual Funds
Mutual funds may seem inexpensive because the costs are hidden. Mutual funds are loaded with fees such as sales charges, management fees, and 12b-1 fees. Sales charges are front-end loads charged by the broker or advisor for buying mutual fund shares, and charges for selling mutual funds shares are back-end loads. These charges depend on the various classes of shares.

For example, Class A shares usually have front-end loads and Class B shares usually have back-end loads. Front-end charges can be as high as 8.5% for Class A shares. This means that an investor with $10,000 is only putting $9,150 to work while $850 goes toward the sales charge.

In addition to sales charges, someone has to manage the fund and therefore, also has to be paid a management fee. This fee can range from 0.10% to 2.00% per year and depends on the fund itself and its investment style.

Another type of fee is 12b-1 which is paid to brokers or advisors to pay for marketing, distribution and service costs. The Financial Industry Regulation Authority (FINRA) allows funds to charge 12b-1 fees as high as 1.00% on an annual basis.

High-Fee Mutual Funds Are Moneymakers
Adding up all of the fees, it is no wonder that mutual funds are popular on Wall Street. It’s a great business because everyone except the investor benefits from this investment vehicle. Unfortunately, for the investor, the returns are not as good as the investment industry promises.

The average investor in a stock-oriented mutual fund generated 5.66% per year over the ten-year period ended December, 31, 2007, according to a study by Dalbar, Inc., a leading financial services market research firm. Notice that this doesn’t include the stock market decline in 2008.

Choose Mutual Funds Diligently
But are all mutual funds bad? No, not all mutual funds are created equal. Saying that all mutual funds are the same would be equivalent to saying that all restaurants are the same. Mutual funds are simply investment companies that make investments on behalf of their investors.

There are some mutual funds that delivered fabulous investment performances for its investors and did not charge outrageous fees. But, the problem is that most of the investment public would never know about them because these funds don’t advertise much, and they don’t pay high commission fees to entice brokers and advisors to sell them. In other words, they don’t play the Wall Street game.

Simon’s Note: Low-cost index funds, from companies such as Vanguard or T. Rowe Price, are a great way to invest without having to deal with the headaches and worries of picking the right mutual fund. ETFs are another great option with super low fees.

(Photo credit: alancleaver)