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  • Writer's pictureEric Hahn

Are You Paying Too Much For Mutual Funds?

When it comes to your investments, you may be paying twice as much for half of the service.

I see managed account options where you pay fees of 2.5 percent a year to own a portfolio of mutual funds, and you pay a $95 transaction fee whenever fund shares are bought or sold. Yikes. That is a lot of money.

Not only are you paying a lot, but you’re also getting little in return. Many investment firms that charge this way provide no meaningful financial planning. And the portfolio returns usually underperform a comparable portfolio of index funds.

In the last week alone, I’ve come across three such high-fee, low-service offerings – and it makes me mad. When it comes to investing, you, the consumer, must get smarter about what you pay, and what kind of value you receive in return. Are you paying double for half the service? Here are two questions to help you figure that out.

What are the expense ratios of the mutual funds you own? According to a Morningstar study that looked at fund performance periods from 2005 through March 2010, the single biggest predictor of mutual fund performance is fund expenses. The lower the expenses, the higher the returns of the fund will be. Think through this logically and it makes sense. A fund with high expenses must earn back its fees before it can begin making money for you. It has a higher hurdle to overcome to move into positive territory.

With a mutual fund, the expenses are referred to as an expense ratio. If your fund has an expense ratio of 1.5 percent, that means that for every $100 you have invested in the fund, $1.50 per year goes toward fund fees.

All-too-often I see these high-fee funds placed inside of a managed account, where another layer of fees are applied, often in the range of an additional 1 percent to 1.5 percent a year. Recently I've seen this high-fee structure flourishing in the managed account options offered within the benefit plans used by our fire departments and police forces.

With this structure you end up paying 2.5 percent to 3 percent a year to own the same underlying investments that you could own for half that price when working with a fee-only advisor who uses index funds. You could own the same underlying investments for one-fourth of the price if you want to manage your own investments.

The first key to figuring out if you are paying too much is to find out what you are paying. Next, you figure out what you are getting.

What are you paying for? All services have a cost. It is up to you to figure out what value is provided for the price you are paying.

A mutual fund packages together a group of stocks or bonds, manages those securities and offers you the ability buy them in a bundle. Of course they charge for this, and some fund structures naturally have a higher cost than others.

Funds that own small company stocks will have higher fees than funds that own large company stocks. Funds that own international investments will have higher expenses than funds that own only U.S. investments. Funds that employ active strategies to try to manage volatility or pick winning stocks will have a higher cost than funds that follow a passive approach of owning an entire group of stocks that fit a certain criteria.

Financial advice that helps you figure out which choices help you accomplish your goals is advice worth paying for. If your financial advisor is compensated based on selling you a certain selection of funds, the advice you are getting may not be in your best interest.

An example of this would be a low volatility strategy I saw offered within a fireman’s benefit plan. The fund’s track record shows that when the Standard & Poor’s 500 index is down, the fund is not down by as much. It has less downward volatility than its benchmark. Great. But how does that help him accomplish his goals?

He is in his 30s and plans to work another 15 years. His objectives span a 15-year time horizon, not a month-to-month measure of volatility. This low volatility fund choice with total fees of 2.5 percent a year, is far less likely to accomplish his goals over 15 years than an S&P 500 index fund. Yet, it may be quite effective at accomplishing its stated goals of less volatility than the S&P 500 index.

You can read a fund's prospectus to see the goals, objectives and expenses of the fund. You can also go to the Morningstar website and search for the fund’s ticker symbol to find this information.

With some funds, as part of the expense ratio, you will see an expense called a “12b-1 fee” listed. If your funds are being managed, some managed accounts credit 12b-1 fees back to you so you are not paying the managed account fee and the 12-b1 Fees. This structure seems fair. If that is not what is happening, I personally believe you are being fleeced.

If you are in a managed account, you will have signed managed account agreement that will tell you what fees you pay in addition to the fund fees, and if 12b-1 fees are credited back to you or not.

I know it can be overwhelming to figure all of this out. Think of it this way. Most people spend time shopping for deals on cars, televisions or clothes. You can save even more by getting a handle on how mutual fund expenses and managed accounts work.

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