When choosing mutual funds for our portfolio too often we get caught up in the returns of the fund while not asking ourselves the most important question. How much does this fund cost? A common thought is the fund which returned the most last year or over the last handful of years must be the best fund and thus the right fund for me, but that is not always the case.
Often overlooked, but extremely important, is the price of the fund. The price of the fund is determined by its expense ratio; an expense ratio of .40% means the fund will charge you 40 cents for every $100 you invested in the fund. This fee is to cover operating expenses of the fund, like transaction and recordkeeping fees, and to compensate the fund’s manager(s).
One reason the expense ratio is overlooked is because it doesn’t come directly out of our account; rather, the expense ratio is rolled into the fund’s price, known by the acronym NAV or Net Asset Value. I bet if we saw the fees we were paying directly debited from our account we’d look more closely at them.
Know that the fee you pay for a mutual fund directly impacts your return. If two comparable funds each returned 7%, and Fund A charged you a 1.00% expense ratio while Fund B charged you a .50% expense ratio then Fund A returned 6% while Fund B returned 6.5%. Clearly, Fund B had the superior return – it made you more money because it simply took less.
Here’s another way to look at it; consider the fee you pay for a fund a big hole in the ground. In order for you to get out of that hole and get back to ground level your fund must generate a return equal to the fee it takes. So Fund A is a 10 foot deep hole, while Fund B is a 5 foot deep hole, it’ll be easier for your fund to get back to ground level when it starts 5 feet deep instead of 10.
Have you ever gone to the gas station across the street because its gas was 10 cents cheaper? The company is different, but you know the gas is the same, so why pay more? It’s the same with mutual funds. If this company’s S&P 500 fund costs .40% and that company’s S&P 500 fund costs .20% would you stay at the station that charges you $4.00 for a gallon of gas or would you go across the street and pay $2.00 for the same gallon of gas?
So how do you find low-cost mutual funds? First off, avoid actively managed mutual funds. Actively managed funds try to beat the market (they will tell you so in the fund’s description or summary), some will, but most won’t, and the ones that do beat the market won’t do it for any extended period of time. In the end, with the significantly higher fees they charge there is almost no advantage to using actively managed funds. Look for mutual funds that have the word ‘index’ in their title. Index funds merely track an index, they don’t try to beat the market – they join it. You will find these funds offered through low-cost mutual fund providers such as Vanguard, Charles Schwab, Fidelity, and Dimensional Fund Advisors (DFA funds aren’t quite index funds, but that’s a topic for a different article).
And don’t just go off of name alone. Research a fund’s expense ratio yourself. You will generally find the expense ratio on the fees and minimums page for a mutual fund, and you will definitely find it in a fund’s prospectus. As a general guideline expense ratio should be under .20% for bond funds; under .30% for US large cap stock funds; under .50% for US small cap stock funds; and under .60% for international and emerging markets stock fund. If you are paying more than these guidelines for your fund, you’re probably paying too much and should seriously reconsider the fund you are in. You should never pay more than 1% for any fund.
Most of us get caught up trying to pick the right fund to maximize our return; the truth is a great majority of the time the right fund is the cheaper fund. Over the long-term consistently being in less expensive mutual funds will yield higher returns than comparable, but more expensive mutual funds.
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