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Watch Out for Fund Expenses by Michael Iachini, CFA, CFP®, Director, Investment Manager Research, Schwab Center for Financial Research November 19, 2007 Updated from the September 2006 issue of Schwab Investing Insights®, a monthly publication for Schwab clients. It's equally true whether you're at the grocery store or buying a mutual fund: Costs matter. With many experts forecasting future market returns in the single digits as opposed to the double digits of the past, investing expenses matter more than ever. But while it's obvious what you're paying for when you buy a gallon of milk, you may not know exactly what your mutual fund dollars are buying. You may also be surprised by how much it matters to your bottom line. What are you paying for? There are two types of expenses when you buy a mutual fund: sales costs, which should be avoided if possible, and ongoing costs, which can't be avoided but which you should keep a close eye on. Sales costs are similar to the commissions you pay when you buy or sell stock, but they can be more expensive for mutual funds. A front-end load, for instance, can eat up more than 5% of your investment! Because this comes out of your investment dollars up front, you also lose out on potential gains from investing that money over time. A back-end load, on the other hand, is charged when you sell your fund before a certain time (such as within eight years), which sounds better than a front-end load until you realize that you typically pay more in annual expenses for a fund with a back-end load. Sales costs could also include a transaction fee, such as $49.95 per trade. Generally, you should consider paying a transaction fee only if you're making a large, one-time investment in a fund and if the fund is clearly superior to the best no-load, no-transaction-fee option. All things being equal, you're better off buying a fund without sales costs. Ongoing costs include three parts, added together to form the fund's operating expense ratio (OER):
What's not included in the fund's OER? The trading cost when a fund manager buys or sells securities. This is made up of:
Not all expenses are created equal Now that you understand the costs of owning a mutual fund, consider how these expenses matter for different types of funds. Conventional wisdom says that expenses are paramount: You should always pick a low-cost fund. Although there is some truth in this, sophisticated investors look beyond simple rules of thumb to evaluate how important expenses are when compared with other factors. Expenses are extremely important for some types of funds but not quite as important for others. When you're picking a bond fund, you expect that returns will be relatively low, and the securities held by different funds are likely to move together, so it's critical that you pick a low-cost fund. When picking a foreign stock fund, on the other hand, you're expecting higher returns and more opportunities for a smart manager to beat the market, so you can afford to focus more on characteristics such as the manager's stock-picking skill and a little less on costs. The Schwab Center for Financial Research studied intermediate-term bond funds and diversified foreign stock funds each month from October 1996 through June 2003 and followed their performance during the following three years. Funds in each group were divided into three equal-size buckets—low-cost, average-cost or high-cost—based on their expense ratios. We found that low-cost foreign stock funds were more likely to outperform their high-cost counterparts. The low-cost foreign funds beat their category average 60% of the time whereas the expensive funds beat their category average only 39% of the time. Bottom line: On average, you would have been better off with a low-cost foreign stock fund. Far more dramatic, however, was the difference between low- and high-cost bond funds (76% vs. 24%). A low-cost bond fund was more than three times as likely as a high-cost bond fund to outperform the category average, and a low-cost foreign stock fund was only slightly more likely than a high-cost fund to beat the category average. When you consider that bonds generally return less than foreign stocks, this makes sense—expenses can eat away a bigger chunk of bond returns. This has been an extremely consistent result, with expenses having a bigger impact on bond funds than on international funds in more than 90% of the three-year periods analyzed. These results were also significant for one-year periods (see the "Foreign Stock vs. Bond Funds" table below). This is why Schwab analysts give extra weight to expenses when evaluating bond funds for the Schwab Mutual Fund OneSource Select List® but focus more on manager skill for foreign stock funds.  Know before you buy Now that you understand the fees you pay when you own a mutual fund, as well as the way those costs impact your performance, you're ready to be a savvy mutual fund shopper. The Schwab Mutual Fund OneSource Select List is full of great funds that we believe will be great bargains (see the table below)—potentially leaving you with some extra change in your pocket at the end of the day. Consider These High-Performing, Low-Cost Funds
Performance data quoted and stated within this article represent past performance and do not indicate future results. Current performance may be lower or higher. Important Disclosures Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Investment value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Approximately 2,100 funds participate in the Mutual Fund OneSource® service. Only these funds, including Schwab Affiliate Funds, are analyzed and eligible to be considered for inclusion in Schwab products, including Schwab Portfolios. Schwab receives remuneration from fund companies and/or their affiliates in these products for recordkeeping, shareholder services and other administrative services. Schwab and its affiliates also receive fees from Schwab Affiliate Funds for investment advisory, administrative and transfer agency services, as well as shareholder and other fund services. The aggregate fees Schwab or its affiliates receive from Schwab Affiliate Funds (see fund prospectuses for more details) are greater than the remuneration Schwab receives from other fund companies participating in these products. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinion are subject to change without notice. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. All charts and research have been compiled from publicly available, proprietary and/or licensed data. Past results are not indicative of future performance. Although the information contained herein is obtained from sources believed to be reliable, its accuracy or completeness is not guaranteed. All expressions of opinion are subject to change without notice. Diversification and asset allocation do not eliminate the risk of investment losses. Small- and micro-cap stocks have historically been more volatile than the stocks of larger, more established companies. International investments are subject to additional risks, such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks. A bond fund's net asset value (NAV) will fluctuate with the price of the underlying bonds and portfolio turnover activity. Return of principal is not guaranteed. Bond fund shares are subject to increased loss of principal during periods of increasing interest rates. Charles Schwab Investment Management, Inc. is an affiliate of Charles Schwab & Co., Inc. Schwab or its affiliates may publish or otherwise express other viewpoints or opinions that may be different from certain viewpoints or opinions expressed in these materials. Investment funds and/or separate accounts managed by Schwab or its affiliates may take positions contrary to the information contained in these materials. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager. (1107-7079) Return to Top |
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