Investing in some mutual funds is like buying a $3 candy bar and paying $5 shipping and handling. All mutual funds are not created equal, and you can boost your returns by doing a little homework before writing a check.
When shopping for mutual funds, avoid funds with loaded sales charges, high 12b-1 fees, high expenses, or a high turnover rate.
Mutual funds that carry a sales charge are called “loaded” funds. The brokers who sell these funds earn their living off the sales charges. There are several types of “loaded funds.”
“A” shares are FRONT-LOADED. They charge a fee each time you buy them (about 4-6%). “B” shares are BACK LOADED. They charge a redemption fee if you sell the fund within a certain number of years. While they hold your investment hostage they often charge significantly higher other fees. “C” shares are LEVEL LOADED. They have no front or back end loads, but their yearly fees are too expensive for them to be called “no-load.” Avoid all loaded funds and buy only “no-load funds.”
Look for direct-marketed mutual funds because they are sold directly to you without a broker or salesperson. The majority of them are “no-load funds”, with no sales fees or loads deducted from your purchase to pay a sales commission.
Named for the Securities and Exchange Commission (SEC) rule that originated it, a 12b-1 fee permits a fund to pay some or all of the costs of distributing its shares to the public. While you own their mutual fund, they are deducting the cost of advertising from the fund’s investments. The more they spend on advertising the lower your investment’s return. Look for a fund with a 12b-1 fee of 0.25% or less.
All mutual funds, regardless of whether they are load or no-load, have management fees and operating expenses. Look for a fund with a low management fee. What constitutes “low” depends on the type of fund. Index funds do not require as much research and should have low fees. Foreign and small cap stock funds require more research and may have higher expenses.
A management fee of 0.5% is low. Management fees between 0.75% and 1.00% are typical. Aggressive and specialty funds will often have higher management fees (1% to 1.25%). You should select a mutual fund with expenses under 1.25%.
A mutual fund buys and sells securities on behalf of its shareholders. The frequency at which they change their holdings is called “turnover.” “Turnover” is measured by the percentage of a portfolio’s holding that are bought or sold each year. A mutual fund with 50% turnover changes half of its security holdings every year.
Mutual fund turnover is bad, and now there is an objective study by Morningstar documenting how bad. Morningstar divided mutual funds into four groups from the highest turnover rates to the lowest. They found that the high turnover funds generated lower returns than the low turnover funds. In some categories the difference was as much as a couple of percentage points per year. You should select funds with a turnover rate under 50%
These four factors can provide a large financial drag on your investments. Choosing mutual funds with higher costs means your investments must gain an extra 3-5% a year to overcome expenses. When stocks were making 30% a year few investors noticed the difference, but in the current investment climate 3% a year is significant. After 20 years, a $10,000 investment growing at 9% will be worth $56,044. With 3% higher expenses it would only be worth $32,071
Advice you can trust
If you rely on a commission-based financial product salesperson, you will probably be sold the wrong kind of funds. You can avoid these expenses by doing the research and purchasing no-load and low-expense ratio funds or you can seek the advice of a Fee-only financial planner. Fee-only financial planners do not receive any commissions, and therefore act in only your best interest.
To find a list of fee only financial planners in your area call the National Association of Personal Financial Advisors (NAPFA) at 1-888-FEE-ONLY or visit their website at www.napfa.org
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