Now that taxes are out of the way, it’s time to think about paying yourself. Whether you are saving for retirement, a college education or just some random future item, you may well be using mutual funds.
Mutual funds are investments that pool money from many individuals. A professional portfolio manager invests the money to meet the particular fund’s investment objective. This way, you get more diversification and expertise than you could get on your own.
Naturally, you pay for this service. Mutual funds have a series of charges. Understand what they are, and you may be able to improve your performance with very little work.
In her book Saving for Retirement (Without Living Like a Pauper or Winning the Lottery), Updated and Revised, Gail MarksJarvis goes through some very simple, very practical advice for selecting mutual funds. A key point is to watch the expenses. “When you give up money by paying unnecessary fees day after day, it sets you back for life,” she writes.
The four fees of mutual funds
The first mutual fund charge is called a load. It’s an upfront commission that you pay when you invest in the mutual fund. Not all funds have loads; most funds that you buy directly from the company come without a load, as do funds included in retirement plans such as 401(k)s. Some funds charge a load when you take money out, especially if you have not owned the fund for very long.
The other charges on a mutual fund are taken out of your assets every year. The fund doesn’t send you a bill, so you might not realize that you are paying these fees. They fall into three main categories: 12b-1 fees, which are used to compensate the financial advisor; management fees, which cover the costs of investing the money; and administrative fees, which pay for legal and accounting services. The total of these fees is reported as the expense ratio.
Loads and expense ratios are reported in the mutual fund’s prospectus. Before you buy a find, look up this information. Then, you can figure out what to do with it.
When is a fee worth the money?
Loads and 12b-1 fees are fine if you are receiving enough advice and support from your financial advisor. One way to measure that is to calculate the dollar amount of the fees and compare it to the number of hours that your advisor has spent with you. For example, if you are going to put $10,000 into a fund with a 4% load, then your advisor will be getting $400 for the transaction. If the fund has a 12b-1 fee of 0.75%, then the advisor will receive an additional $75 per year. If you are getting advice that is worth that much, then the fees are worth it. If all the advisor does is take your order and ignore your phone calls, well then, they’re probably not.
Management and administrative fees should be considered separately. What matters is performance net of fees, so a fund with high fees that also has great performance may well be worth your while. However, investment research firm Morningstar has found that the funds with the lowest expense ratios had the best performance in just about every time period and category examined. In other words, people rarely get what they pay for.
Shop around for the best fund
You can use this information to improve your performance with very little extra work. When you receive your company’s list of 401(k) choices, go through and find the fund in the appropriate investment category that has the lowest expense ratio. When you talk to your advisor, ask if she can recommend another fund with the same investment objective and same load but with a lower expense ratio.
Investing is just another form of bargain shopping. Once you know the total costs of ownership, you can figure out if the benefits are worthwhile. And once you realize that, the process should be much less intimidating.
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