Q. How much does it cost to own a mutual fund?

A. More than you think.

Most investors know about a fund’s expense ratio, and use that attribute for comparing various funds before buying. But there are a host of hidden costs that are much more difficult to uncover for many mutual funds.

That’s what this article from the Wall Street Journal is about.

These hidden costs are related to the buying and selling of the individual securities held by the mutual fund, and they can make a fund 2-3 times more costly than the expense ratio alone would imply. That can be a pretty significant amount on a fund with an expense ration in the 1-2%.

While the expense ratio is an important consideration when pricing a fund, it simple doesn’t capture all the costs. The reason is that every mutual fund and its associated expenses is different. Then there’s the complex nature of the costs not covered by the expense ratio, specifically: brokerage commissions, bid-ask spreads, opportunity costs and market-impact costs.

And since the SEC has yet to mandate any unified form of measurement, the individual is left to try and scrutinize the often inscrutable. Even most experts arrive at drastically different estimates of the true cost of mutual funds.

So how do you find the true cost of mutual funds?

While it is difficult to get at the information required to determine the exact cost of a mutual fund, it turns out that the fund’s Annual Holdings Turnover ratio is a pretty good clue. While it is an imperfect measure, it is a standard measure. So, every fund must report this data the same way.

A fund’s annual turnover ratio is the percentage of assets that were replaced over the past year. So if the fund’s manager sold half its stocks and replaced them with an equal value in new stocks would have turnover of 50%. This is an imperfect measure though because in some cases, a fund can take in a lot of new money and not have to sell any assets to buy new ones. In such a case, the fund would incur additional buying costs that would not be accounted for in the expense

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With thousands of mutual funds to choose from, picking the “right one” can be a daunting task. Most investors know not to fall for a short term hot streak – one or two years isn’t a long enough track record to show superior skill of the management team over sheer luck – but where should you start?

Step 1.  Figure out what you really need.

To be a successful investor, be it in mutual funds, hedge funds or whatever, you need to determine what your objectives really are and what asset allocation you’ll need to meet those objectives. And sorry to tell you this, but “to get rich” is not an objective.

Objective.

For your objective to be meaningful and achievable, it needs to be specific. If you can determine exact numbers, then you’re off to a great start. But even if the numbers are not exact or may even be unknowable, you can still use that as an objective.

For example, if your objective is to have $25,000 in 5 – 7 years for a new car, then you have a defined timeframe, and target amount. From that you can then figure out how much you can invest over that time  frame and see how much return on your money you’ll need to get there. (There are calculators for this kind of thing).

Even if your objective is a bit less knowable, say saving for retirement, you can use ballpark figures for determine the “best guess” for what you’ll need 15, 20, even 30 years out from today. The key is knowing that this is just a guess, based on current trends. In the case of retirement planning you reevaluate your goals and assumptions on a regular basis, every 5 -10 years for example.

The Takeaway. The point to take away from all of this is that your objective (amount and time frame) will be a key component in determining your risk level and asset allocation. You can (and should) invest more heavily in stocks for retirement which is decades away than for the objective that’s 5-7 years away.

Asset Allocation.

Put simply, an asset allocation is which types of investments you choose to put your money in, and in what proportions.

Different types, or classes of investments carry with them different levels of risk and average return. Bonds, for instance, are typically less risky than stocks, though that is a generalization since there are subclasses of stocks and bonds that can be very similar in terms of risk and reward.

Key points of concern are correlation (how much one investment be behaves like another), volatility, and risk.

The Takeaway. Some studies have shown that asset allocation alone is responsible for up to 90% of your total return, so be sure to study up on this stage and know what you’re doing.

Step 2. Picking mutual funds.

Since this article is about mutual funds, I will focus on that aspect of an asset allocation. But remember – if your investment goals are short term, then mutual funds may not be right for you.

Searching for a mutual fund.

If you have an idea of what type of fund you’re looking for, say a small cap stock fund, and you’d like to see what mutual funds fit that category, you can use Kiplinger’s Fund Finder. This tool allows you to select broad categories (like small cap stock funds) and narrow the results by a host of criteria, including:

• 1,3 or 5 year return.
• Morningstar rating.
• Return in a down market (i.e. worst loss).
• Expense ratio.
• Turnover ratio.
• Length of time the current management team has been in place.

And much more. It’s very handy for gathering a list of mutual funds to choose from, but you still need to do some comparison work, but more on that in a minute.

Gathering information on a specific fund.

Once you have a list of funds, or maybe you’re looking for details about a specific fund in your 401(k), you can use FINRA’s Fund Analyzer to get the specifics about a fund.

These results include average return of a given investment amount over a specified period of time, and the total expenses. It also provides a breakdown of the allocation within the fund, investment style of the fund (i.e. growth, vs value, etc..) the Morningstar rating and much more.

Some thoughts on past performance not guaranteeing future results…

By now I’m sure you’ve heard that familiar phrase of investment marketing: “Past performance is not a guarantee of future return”, or something similar. It’s usually uttered as a means of protecting themselves from costly liability in court situations, but it is also a significant thing to bear in mind when picking a fund.

The thing to remember is that just because a fund had a rip-roaring 3 years does not mean it’s going to continue to rip and roar its way up the charts for the next 3 years. Maybe it was a small cap stock fund and the economy has just come out of a recession. If that’s the case, then you can expect those returns to level off a bit as the economic cycle matures and investors seek blue chip companies over small cap.

But long term performance can be a good indicator of a fund’s quality. Look for good for funds with good performance over a 5-10 year period.

Some thoughts on volatility…

Volatility is simple a measure of how much the fund’s price jumps around; it’s a measure of how much of a roller coaster ride the fund is. The lower the volatility, the smoother the ride, but not necessarily the higher return. The thing to keep in mind with volatility is that it doesn’t matter how bumpy the ride is if you don’t need the money for another 20 years. In other words, volatility is less important for long term investments.

Some thoughts on Managers…

Things you’ll want to know about the fund’s manager include:

• Does the manager admit mistakes?
• Does the manager respect the investors?
• Does the manager sound too greedy?
• Does the manager know what he’s talking about?
• Is the manager personally invested in the fund? (that’s a good thing)
• Does the manager stick to his stated strategy?

One last thought about fees…

Not all funds are created equal, and one of the biggest defining characteristics of a fund may be its fees. All other things being equally, higher fee funds will perform worse than lower fee funds. But things are rarely equally and the thing you need to find out is whether the higher fee fund significantly outperforms its peers over an extended period. In other words, is it worth the extra money? If it’s just doing the same as an index fund, it’s not worth the money.

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Morningstar has released their picks for Best Mutual Fund Managers of 2009. It’s important to remember that the competition is intended as an acknowledgement of past achievements, not as a recommendation for future performance..

That being said, the rankings are determined by a number of factors, not just best return for the calendar year. And the results are given in three categories: Domestic equities, international equities, and fixed income.

Here are the winners.

Domestic Equity

Bruce Berkowitz of Fairholme Fund (FAIRX)
2009 Return/Percentile Rank: 39.0/9th

The Fairholme fund returned 39% (12.5% better than the S&P 500) despite not holding any technology stocks and keeping 17% in cash!

Much of what made this fund perform so well is what the Mr. Berkowitz did in 2008 and 2007.

International Equity

The Team at American Funds EuroPacific Growth (AEPGX)
(Stephen Bepler, Mark Denning, Robert W. Lovelace, Carl Kawaja, Sung Lee, Nicholas Grace, Jonathan Knowles, and Jesper Lyckeus)
2009 Return/Percentile Rank: 39.1%/15th

This fund did so well because the management team was in the right place at the right time – developing markets (i.e. emerging markets!), which went on a tear in 2009. The also reduced their cash stake to 5% in time to catch the market bottom and ensuing rebound. Nice work.

Fixed-Income

The Team at Loomis Sayles Bond (LSBRX)
(Dan Fuss, Kathleen Gaffney, Matthew Eagan, Elaine Stokes)
2009 Return/Percentile Rank: 36.8%/14th

This team owes its success to a contrarian approach and the discipline to stick to that approach when times got really tough. The team went bargain hunting in corporate bonds just before the bottom fell out in 2008, and panic ensued.

They kept to their plan, convinced that the panic was overblown, and it paid off… to the tune of a 36.8% gain. Not too shabby for a fixed income fund!

Be sure to read the full article from Morningstar to get all the details on these terrific managers, as well as the process for picking them.

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Picking a mutual fund can be a daunting task, but here are 5 things to look for that I hope will help make the process a little easier. This is part of my weekly Mutual Fund Monday post feature. If you find this interesting or helpful, please read more.

1. Fees.

Over the entire time you own a mutual fund, fees can sap returns without you even knowing it. Fees are also the single easiest thing for an investor to control. You can’t always choose the hottest performing fund, but you can choose the one with the lowest fees. Also, many fund companies don’t tie fees to performance, so your fund manager gets the same financial incentive whether he beats his benchmark or falls short.

Look for low cost index funds, or fund families like Vanguard, Dodge & Cox and American funds. Also, look for families that tie compensation to performance like Vanguard, Fidelity, Bridgeway and Janus.

2. Size.

Fees matter, and so does size when it comes to mutual funds. When a fund gets too large, the manager cannot buy and sell many assets without affecting the price of those assets by his actions. This makes it very difficult to perform well. Think of it as the difference between steering an 18-wheeler and a motorcycle. You want a fund that’s small enough to be nimble and not have to fight against its own momentum.

Look for fund families that don’t let their funds grow too big. Funds that aren’t afraid to close the doors to new investors when the fund reaches a certain asset size. Families like Dodge & Cox, Longleaf Partners fit into this category. Also watch out for funds that announce they will be closing well in advance as this often signifies that the management is looking to make a last minute asset grab, and does not have the best interest of the shareholders in mind.

3. Age.

Pay attention not only to how old the fund is, but also how old other funds form the same family are. For example, avoid companies that seem to launch funds targeting “what’s hot” at a given time – think tech stocks in 1999, or emerging markets in 2006.

Look for fund companies with a long history of concentrating on fundamentals and not simply trying to capitalize on fads. Companies like Longleaf, FPA, and Dodge & Cox fit this metric.

4. Taxes.

Some managers simply don’t care about your tax bill, and that’s fine if you hold those funds in a tax sheltered account like a 401(k) or IRA. But if it’s in a taxable account, it’s an unnecessary drag on your return.

Look for funds with low turn over rate, and a small difference between before and after tax returns.

5. Benchmark.

Lastly, you should pay attention to the benchmark of a fund. You’ll want to know what the fund is using as its benchmark as well as how it performs in relation to that benchmark. But most importantly, you should look at the absolute return on the money invested. For example, if the fund lost only 35% when its benchmark lost 38%, it’s really not getting you much, is it?

Look for how the fund performs is good markets and bad markets. Be sure you can handle that worst case scenario because you can rest assured that it will happen to you at some point in your investing life. Try and find funds that capture most of the upside of the market, while limiting the downside as much as possible. For example, a large cap stock fund that returns 75% of the S&P 500 during a bull market, and loses as much as 50% compared to the S&P 500 during a bear market would get you a smoother ride and potentially larger return, provided you are holding the fund through both periods.

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Chuck Jaffe at MarketWatch has a great piece that I thought I’d share for my (semi) weekly Mutual Fund Monday post this week.

His article lists 7 ways that fund companies manipulate their stats to trick investors. It’s all quite legal, since much of it depends on your the viewpoint and perspective applied to the facts and figures. For example, how far back do those “past performance” figures go? A fund may look great only because it has an explosive couple of years at the beginning of the period, and has been lack luster since.

Anyway, here’s a list of the ways but Chuck does a good job of explaining each in greater detail in the original article.

1. Past performance, Part I
2. Past performance, Part II
3. Past performance, Part III
4. Average Cost
5. Returns aren’t adjusted for taxes
6. Time-weighted performance measurement
7. Manager tenure

You will have noticed, no doubt, that the 1st three items on the list have a common theme. That’s because even though most investors know that “past performance is no guarantee of future results”, it’s still the single characteristic that carries the most weight with investors. Mutual fund companies know that, and they use it. A lot.

Here’s Chuck Jaffe, in his own words.

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I’m down with the flu this week, which means I’m taking it easy – but not too easy. I’m catching up on some reading and found some nuggets of knowledge regarding mutual funds that you may not already know about and you may enjoy reading. So, without further ado (because I need to get to bed now), the blogs:

First up, from  The Oblivious Investor, comes
11 Tips for Selecting Mutual Funds. This short, concise list of things that matter (and why they matter) when picking a mutual fund will ensure you get in the right frame of mind, before you do anything rash and costly.

Next, the Amateur Asset Allocator has a great primer on the various Types Of Mutual Funds that will help sort out the differences between open-ended, closed-ended, indexed vs. actively managed and more.

And lastly, while we’re on the subject of index funds, Retirement Savior reminds us that some mutual funds do outperform indexes, and tells us when (and why) When NOT to Use Index Funds.

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Investors who own shares of mutual funds are probably familiar with the 3 most common classes of shares: A, B, and C. But recent market conditions have led over 400 mutual funds to eliminate class B shares form their offerings.

The reason for the elimination is cost. It simply costs the fund company less to offer fewer classes of shares.

Class-A Shares charge a front-load commission that is taken off your initial investment.

Class B Shares often carry deceptively high annual fees.

Class C Shares charge a fee when you sell the shares.

The tracking and bookkeeping is apparently not worth the return on B class shares for many fund companies. Given the fact that class B shares can be automatically converted to Class A shares after a certain period of time, it’s easy to see why they can be an added hassle for fund companies. This is especially true if investors are trading more frequently, and the company would make more on the buy and sell loads charged from class A and C shares.

For a much more detailed overview of the definitions and differences of mutual fund share classes, see The ABCs Of Mutual Fund Classes at Investopedia’s site.

For a better option, you might want to look into ETFs. The only load they carry is the brokerage commission, which can be less than $10 at most online brokers.

There is no correlation to paying higher fees, and earning a greater return on your investment so why pay more?

Case studies.

Here are 3 big-name mutual fund companies that have recently eliminated their class B share offerings.

American Funds. Citing a loss of investor interest, American funds eliminated it’s B shares in April. Maybe the lack of investor interest was due to the fact that the B class shares charged investors a penalty if they were sold within 7 years of purchase.

Evergreen Investments is a subsidiary of Wells Fargo. They eliminated their class B offers in June stating a desire to respond to “client needs.”

Charles Schwab had no load funds anyway, but still eliminated its share classes for simplicity.

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Morningstar has their Morningstar’s Six Top Candidates for International-Stock Manager of the Year available on their website.

This is worth a look because if you’re thinking of investing in international mutual funds, you’ll want to make sure the fund has a good manager. One way to pick good funds is to follow good managers.

With the market mayhem over the past year, the winners will really be separated from the losers – it’s hard to manage a successful fund under these conditions when you’re a follower engaged in group-think. Times like these allow the cream of the management crop to rise to the top.

That doesn’t mean that this is a list of the best for 2009 only. Each manager on this list has a solid, long term track record but has also done well so far this year.

Here’s the list:

• The Team at American Funds EuroPacific Growth (AEPGX)

• The Team at Dodge & Cox International Stock (DODFX)

• David Herro and Rob Taylor of Oakmark International (OAKIX)

• Brent Lynn of Janus Overseas (JAOSX)

• The Team at Manning & Napier Worldwide Opportunities (EXWAX)

• Justin Thomson of T. Rowe Price International Discovery (PRIDX)

You will have noticed that most of these are teams, and not individuals. Also, they are not official nominees, just front runners so far.

Read the full story to learn why they’re considered front runners.

• Mutual Fund Monday - What 2009 Trends Mean for 2010. Many investors take the change in calendar year as an opportunity to assess their portfolios and the future, and hopefully get their portfolios aligned with the future direction of the stock market. One way in which to do this is to look back on the year that's passed and see......
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Investors in U.S. mutual funds might want to keep an eye on this. The Committee on Capital Market Regulation (CCMR) has recently issued a report by Harvard professor John C. Coates which recommends that mutual fund regulators eliminate the requirement for yearly capital gains distributions.

The change would only affect investors who own less than 2% of outstanding shares in any given mutual fund, but I imagine that’s most individual investors.

If the recommendation were to go into effect, capital gains would be deferred until the fund was sold, just like individual stocks. Coates has made the recommendation because he believes it will help make U.S. funds more competitive in the international market, but it would also help bring a tax break to investors as well as improve consistency in the capital gains treatment.

This would be a pretty big change since, mutual funds sold Europe are not required to pay a capital gains distribution at least once per year.

Read the report here (PDF)

• Mutual Fund Share Class Comparison Gets Easier. Investors who own shares of mutual funds are probably familiar with the 3 most common classes of shares: A, B, and C. But recent market conditions have led over 400 mutual funds to eliminate class B shares form their offerings. The reason for the elimination is cost. It simply costs......
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