A low expense ratio is a key consideration in choosing a mutual fund, but the definition of "low" varies by fund type.
Choosing quantitative funds—which select investments using a mathematical formula—can lower expenses; fundamental funds, on the other hand, have a human touch.
Passively managed mutual fund costs are among the lowest, but actively managed funds can react to market changes.
Certain mutual fund expenses and fees, such as administrative costs, advisory fees and distribution fees, are included in a fund's operating expense ratio. These costs are disclosed clearly to investors. Transaction costs—the actual cost of buying and selling securities—are passed on to investors, who might not realize they are shouldering these added mutual fund expenses.
Do these mutual fund fees matter to the investor? Absolutely. Simply explained, a fund with high costs must perform better than a low-cost fund to generate the same return. And even small differences in fees can translate into large differences in returns over time.
But fees shouldn't be the lone factor in determining the validity of an investment. Higher costs may be worth it if they support an investor's particular needs or generate higher returns. Sometimes, you'll want exposure to markets or sectors represented by funds that are inherently more expensive than others. That's fine, as long as you're aware of the expenses baked into them, and take on that extra expense knowingly. Following are three factors that typically contribute to a mutual fund's overall cost.
1. Mutual fund expense ratio
A mutual fund's most important cost metric is its expense ratio, listed in its prospectus as "Total Annual Fund Operating Expenses." The greater the mutual fund expense ratio, the more difficult it is for a fund to perform better than the overall market.
Let's look at the expense profile of stock funds.
- Large-cap equities: Most large-cap equity funds have lower costs for both research and trading. Bigger companies are more widely traded, which reduces trading spreads, and the lower trading costs are passed on to mutual fund investors.
- Small-cap equities: These funds sometimes spend more for research and analysis because information about smaller companies can be more difficult to find. Also, smaller companies typically have higher trading costs because they aren't as widely traded as larger companies. The very nature of a small-cap fund means that if it's successful, it's likely to sell investments more frequently than funds that invest in larger companies. This turnover results in more trading fees, but a small-cap fund that doesn't sell its successes may soon become a mid-cap fund.
- International equities: These funds often are among the most expensive mutual fund investments because they might need to rely on global staffs to help them invest and monitor performance in numerous countries. Some also hedge their investment exposure by purchasing foreign currencies, which can add to expenses.
Now, let's look broadly at the expense characteristics of bond mutual funds. As a rule, bond funds have lower expense ratios than equity funds but there are variations. As with stock funds, investors should generally look for an expense ratio that is below the category average—1% for a taxable bond fund, in our opinion.
- Domestic bonds: Domestic bond funds typically incur lower costs than high-yield or international bond funds. They generally invest in high-quality government issues and corporate securities with low trading expenses. Domestic bond funds generally have lower operating expense ratios than equity funds.
- High-yield and international bonds: Managers of high-yield bond funds conduct fundamental research on corporate securities, which can add to costs. Like small-cap equity funds, high-yield bond funds typically invest in securities that have lower trading volumes, resulting in higher transaction fees. And international bond funds tend to have higher expenses for many of the same reasons as their equity counterparts.
2. Quantitative vs. fundamental research
Another expense consideration involves whether to invest in a quantitative ("quant") fund or a fund rooted in fundamental research. Quants typically have lower expenses than other managed funds because they choose investments based on an algorithm. By comparison, a fund that uses investment professionals to research companies' fundamentals requires more human capital, and therefore tends to have higher expenses.
Because quant funds' investment decisions are driven by mathematical analysis, they may have more turnover. This can lead to higher trading costs, even if the fund's overall expenses remain below those of funds managed on fundamentals.
3. Active vs. passive management
Passively managed funds, such as index funds, are attractive because of their low fees. They don't require active management—they simply track the indices they represent—so their costs are among the lowest in the mutual fund world. Passively managed funds also tend to be more tax efficient.
Index funds are especially attractive for investors who believe fundamental analysis adds little long-term value and that tracking the broader market over time generates the most reliable returns. Index funds, may, however, leave investors more vulnerable to market downturns than some actively managed funds, as many investors learned in 2008. So, some people may be willing to pay more in exchange for an actively managed fund that is designed to react to market changes.
Good news all around
The good news for investors is that mutual fund fees are falling. Faced with mounting pressure from index funds and exchange-traded funds, active managers are slashing costs. Expense ratios for US funds fell last year, even though they remain high in Europe and elsewhere in the world, according to a recent study by the Investment Company Institute, a U.S. mutual fund industry trade group.
It's important to reemphasize that mutual fund fees, alone, shouldn't determine an investment strategy. If higher-cost strategies are helping to diversify a portfolio and/or generate higher returns, the additional costs may merit consideration. Nonetheless, investors need to know what they're paying for.
1."Trends in the Expenses and Fees of Mutual Funds, 2012." ICI Research Perspective, April 2013.