Managing Money : New Rules Help You Spot Mutual Fund Fees
Recent modest performances by mutual funds, along with recent actions by the Securities and Exchange Commission, again spotlight how high fees and expenses can erode your investment returns from a mutual fund.
Impartial experts have long argued that big fees--ranging from up-front sales commissions, or loads, as high as 8.5%, to annual management fees and other yearly expenses sometimes exceeding 2% of your investment--can take a huge chunk out of your return. All else being equal, you should find top-performing no-load or low-load funds with low annual expenses.
The search for low-cost funds is even more important now because less favorable conditions in bond and stock markets mean that investors probably can’t expect the double-digit annual returns of recent years to continue. Those high returns often masked the effect of high fees and expenses.
“It’s easy to hide expenses in a bull market,” says Brian Mattes, spokesman for Vanguard Group, the fund company generally regarded as having the lowest overall fees and expenses. But in these times, “a 1% higher annual fee could add up quickly,” Mattes says.
For example, if you invest $10,000 in a no-load fund with annual expenses of 0.5%, you will end up with $15,037 after five years, assuming an average return of 9% a year, Mattes argues. But raise that expense ratio to 1.25%, and your return is diminished by $513. Keep the same 0.5% expense ratio but add an 8.5% up-front load, and your return shrinks by $1,279 (largely because your initial investment is only $9,150, not $10,000, since the load comes right out of your initial investment).
Farther out, the gaps widen. After 10 years, the no-load fund with low annual expenses ends up being $1,715 better than the high-expense no-load fund and $1,922 better than the high-load fund.
Unfortunately, many novice investors ignore the impact of fees, paying high charges partly because they are unwilling or unable to do the research to find low-fee funds--even though these inexpensive funds are abundant and on average perform just as well as high-fee funds. Or they are misled because fees are obscured or hidden.
Or, as is probably the case with most investors, they are sold high-fee funds by brokers who downplay the negative effect of those charges. Many of these high-fee funds have been bond funds--just the type where high fees should be avoided because supposedly you are buying them for their high yields, and because it is easier to find similar bond funds with lower charges than similar stock funds.
The SEC came at least partially to the rescue earlier this year. Starting May 1, it required each fund to present a uniform table of fees near the front of its prospectus. Previously, those fees were often spread all over the prospectus and were couched in legalese to obscure their effect.
The SEC also required funds to show in their prospectuses how fees will affect a $1,000 investment over time. This greater disclosure, the SEC reasons, will make it easier for investors to compare fund costs--although many investors still don’t bother to read prospectuses carefully.
Then, a little over a week ago, the agency proposed to go further. It gave preliminary approval to a rule that would forbid funds that charge so-called 12b-1 fees to call themselves no-load funds in their advertisements, prospectuses and other materials.
These 12b-1 fees, named after the section of the securities law creating them, can be used for a fund’s marketing and advertising expenses and are charged by about 40% of stock and bond mutual funds. The fees typically run between 0.25% and 1.25% a year--meaning you pay them each year for as long as you own that fund, unlike front-end loads that you pay once when you buy into the fund or so-called back-end loads that you pay once when you leave.
Some fund groups in recent years have dropped front-end loads, enabling them to call themselves no-load funds, in hopes that would attract investors. Many of those funds, however, then added 12b-1 fees or back-end loads, perhaps hoping that investors wouldn’t notice because these charges aren’t paid up-front. In some cases, a portion of those 12b-1 fees have been used to pay sales commissions to brokers--a function previously held by the front-end load.
The new proposed SEC rules would limit a fund’s use of 12b-1 fees to pay sales commissions. Specifically, it would require that 12b-1 proceeds for a given year can only be used for sales expenses in that year. That would crack down on a practice in which funds pay large commissions to salespeople up front but then reimburse themselves over several years through 12b-1 fees.
“There’s a need for increased and better disclosure to shareholders,” says Mary Joan Hoene, deputy director of the SEC’s division of investment management, which oversees mutual funds. “The fact that 12b-1s are used for commission payments is a development that consumers need to understand.”
Not surprisingly, the mutual fund industry is fighting this last proposal, arguing that many funds with 12b-1 fees would scrap them and reinstitute or raise front-end loads. That would deprive investors of a choice between higher annual fees in the form of 12b-1s rather than high up-front sales fees.
The 12b-1 fees instead of up-front loads “give you an alternative as to whether you want all or most of your money working immediately for you,” says Michael Delaney, spokesman for the Investment Company Institute, a mutual fund trade group. Indeed, if you hold your fund shares for only a short period, you are in fact better off incurring 12b-1 fees rather than big up-front charges, Delaney argues.
The proposed changes are subject to a 90-day comment period and then must be approved by the full commission before taking effect.
Regardless of the outcome, the SEC’s proposals serve a useful purpose by calling attention to 12b-1 fees.
Also illustrating the potential negative effects of 12b-1 fees is a new study by Financial Planning Information Inc. of Cambridge, Mass.
The study, which looked at annual expenses of hundreds of funds, shows that funds with 12b-1 fees on average charge 1.45% in annual fees, versus 1% for funds without those charges. Over 10 years, that’s a $917 difference in return on a $10,000 investment earning 8% annually, says Jonathan D. Pond, president of Financial Planning Information.
The study also shows a wide variance in annual fees among similar types of funds (the average among all funds is 1.15%). Some funds have annual fees as high as 4%.
“Clearly some fund families are just greedy,” Pond says.
The answer, of course, is to shop around and find top-performing no-load or low-load funds with low annual expenses and low or no 12b-1 fees. According to Financial Planning Information, no-load fund groups with below-average annual expenses include Dreyfus, T. Rowe Price, USAA and Vanguard. Not coincidentally, these don’t charge 12b-1 fees. IDS and Federated also have below-average annual expenses, but they charge either up-front or back-end loads.
By contrast, fund groups with above-average expenses--largely because of high 12b-1 fees--include Bull & Bear, Dean Witter, Drexel Burnham Lambert, Investment Portfolio (offered by Kemper Financial Services), Keystone and Thomson McKinnon. Of these, only Bull & Bear tends not to have front- or back-end loads.
