When purchasing a mutual fund, what is the most important piece of data you must know before entering into a fund?
You need to know what the expenses are, and specifically, what in total, the fund is charging you. The most efficient method to measure the total expense of the fund is the Expense Ratio.
In the mutual fund world, there are tons of charges added to your bill at almost every turn. Previously, I had discussed several different types of expenses (or Loads), and what to watch for when picking a mutual fund. To revisit that article, please click here for a refresher
The expense ratio is designed to cover the cost of several items regarding the mutual fund. The most common types are the following: Investment Advisory Fee, administrative costs, compliance, management, distribution, 12b-1 distribution fees, marketing, shareholder services, other operating expenses, record keeping fees.
As you can see, mutual funds have tons of extra costs. Some are obvious, but many are ‘buried’ in the prospectus, which will add to the cost of your fund, and ultimately cost the investor a sizable percentage of their total return on the investment. By SEC rule, all the costs will be seen in the prospectus under the heading, Shareholder Fees (a must read for any investor).
Lets look at a random example, so we can understand where the expenses start, how much the % is, and what a $5,000 investment really means in a fund. For this example we are going to take a look at Sterling Capital Large Cap Value
Posted below is the annual return data from the fund. To see the data in the Zacks.com web page, please click here
But before we see what our returns would have been, we need to look at all the expenses associated with this fund
. The chart below shows the breakdown of the expenses, and the ending expense ratio for the fund.
So we first look at %Max Sales Load, and for this fund it is 5.75. That means, you will lose 5.75% of your money before you purchase 1 share of the fund. This Sales Load, typically covers the initial meeting with the fund manager, and that’s about it. So for your initial $5,000 investment, you actually purchase $4712.50 worth of funds, while $287.50 goes to the broker.
So you have not purchased a share, and you have already lost 5.75% of your investment.
Next comes the 12b-1 fees of 0.25% per year (and every year you have the fund’s shares), and then the 0.7% management fee, which is paid out to the fund advisor for picking the stocks each year you hold the fund.
So now, you have to think, how long am I intending on holding this position. You have to remember in this fund (and many funds like it), you are paying your entry fee, or an exit fee, and then a fee each and every year you hold the position. In essence, you are paying 1.06% of your assets (if you made money or not) each year you are in this fund.
To understand how much money we are talking about, lets first look at this fund’s total assets, $33.55 million dollars (as of Aug 2014). Now understand that your fund manager gets 0.7% of your assets and everyone else’s assets in the fund, which would translate into a nice paycheck of $234,850 for the fund manager in just management fees (not including the $287.50 that you and everyone else paid when entering the fund).
The 12b-1 fee, in total for the fund, would end up being $83,875, which is pays for marketing, and management fees (AKA another commission to the fund manager). Remember, these are annual fees, so next year it is another $234,850 to the fund manager, and another $83,875 for marketing. As you can see, it pays to be a fund manager.
Break Down of Your Investment
The table below shows the total return for both the investor and the fund manager for years 1-10. As you can see these fees really start to pile up, and take away from the investor’s total return.
*note, this article is an exercise in basic expenses, but if you calculate in the three years of capital gains, the exercise would become much more complex, and for this example the three data points will not make much of a material difference in the final numbers.
As you can see, you the investor, made $2844.10 ($7,556.60-4,712.50), and the broker made $981.30 during the same 10 year period of time. If you notice that 2007, 2008, and 2011, all had negative returns, but the broker still made money. So no matter if you win or lose, the broker always wins.
Below is chart showing the gains by both sides, during this same period of time.
As you can see, the fees actually are almost 2% each year, not just barely above 1% as advertised, due to the compounding the fees over time.
Disclaimer regarding the Fund
Please understand I am not attacking or saying the Sterling Capital Large Cap Value fund is bad in any way shape or form. Actually, when I wrote this article, BBTGX, was ranked a Zacks #1 Strong Buy. I just wanted to show you, the investor, a breakdown of a typical fund that has different types of loads, and how it impacts your bottom line over the long and short term.
It is the investor’s responsibility to read the Shareholder Fee section of their fund’s prospectus, and not reading or fully understanding the fees associated with a particular fund, could and probably will negatively impact your investing goals. It is worth taking an hour out of your day to calculate the total cost of each mutual fund investment and not just look at % Total return over 1, 3, 5, and 10 years because they will be two totally different numbers.
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