What is the real cost of purchasing and owning a mutual fund?

Many local mutual fund investors aren't really sure, even if they are truly conscientious and read all of the fine print in the investment materials. Part of the information problem is the lack of sophistication of offshore Internet mutual fund reporting particularly compared to the US reporting standards.

All mutual funds must issue a prospectus that tells you everything about the mutual fund structure, investment policy, managers, administrative costs, sales commissions, risk of capital markets and so on. What the prospectus does not do is compute for you the real cost of owning a mutual fund over a period of time.

Do you have any idea what the fees charged are in your pension funds? They are mutual funds, aren't they? Pension funds also have to be audited. Do you know who picks up the tab for that, the pension administrator, or the investors?

The sale commission remunerates the mutual fund salesperson who places your money into a particular fund, anywhere from one percent to seven percent of your investment. There are also administrative and other expense fees that pay for the mutual fund managers, who manage the fund within the guidelines of the investment policy.

An experienced mutual fund manager will use every single bit of his/her investment acumen and knowledge of capital markets to bring in a decent return, thereby appreciating your asset. And you want experience and consistency in a manager, not a fund that has seen lots of turnover in investment managers. You want a decent track record such as Bill Gross of the PIMCO Investment house. Globally famous, he has successfully managed the $50 billion PIMCO Total Return Fund for many years.

Do Term deposits charge these fees?

Let's look at Plain Vanilla Term deposits; they pay a fixed rate of interest every year and charge no administrative fees. If the interest rate is six percent (we wish - more like 2.5 percent), what you see is what you get - six percent a year for the term of the deposit. Why would any financial institution want to be in the business of paying depositor's interest? Ah, because they loan out that float (your money) at a higher rate. The difference between the deposit and loan runs the financial operation and hopefully makes a profit and in the business world, there has to be a profit motive. Indirectly, the cost of doing business will affect the interest rate paid to the depositor because the financial institution cannot stay in business if deposit interest paid out is too high in proportion to debt interest paid back.

A real drag

In many instances, sales commissions and fees are a real drag on performance, but there have to be some fees for operation. The investor challenge is to find a high performance mutual fund that charges competitive ones.

Consider the first example in the chart - this $10,000 investment in XXX mutual fund with a one-time five percent front-end sales commission and a 1.5 percent administrative fee, charged annually, cost the investor $650 right off the top. It is simple math to calculate that just to break even the first year, the mutual fund must return more than seven percent. Not many large cap growth funds have returned that average in the last three years?

YYY fund has no sales commission up front and 0.5 percent annual fees for a cost of $50 a year. The differences in expense fees can cost dearly. Do your comparison-shopping; some Canadian funds and other offshore brands report annual expense fees of 2.5 percent or more. It's interesting to note that an individual portfolio manager generally charges less than that.

The long haul

Some mutual funds have high charges plus excellent track records. The investor should be purchasing a good fund that will be held, no less than five years, but preferably ten to 20 or more years. In that time frame, not only will a superior mutual fund outperform its benchmark and its peer group, but it will more than compensate the investor for paying the higher purchase fees. So should you really pay attention to how well your mutual funds perform? Of course, and you should know before your purchase what all of the fees will do to the performance.

The United States Securities and Exchange are concerned about small investor financial education and have built a Mutual Fund Cost Calculator Tool on their website. Best of all you can use this Tool for Comparing Mutual Funds for both onshore (US) or offshore products. The Mutual Fund Cost Calculator enables investors to easily estimate and compare the costs of owning mutual funds, by taking the mystery and math out of the cost equation.

Read the fund's prospectus and shareholder reports, and scrutinise the fund's fees and expenses. It takes only minutes to use the SEC's Mutual Fund Cost Calculator to compute how the costs of different mutual funds add up over time and eat into your returns.

The cost calculator will the compare your funds based upon the premise that the total cost is the sum of the total fees paid plus the foregone earnings. Go to the website http://www.sec.gov/investor/tools.shtml. You will find it very helpful. The Cost Calculator is great for understanding the effect of fees, but costs aren't the only thing that should be considered when buying a mutual fund - we will address those in another article.

For more information about mutual funds, read the SEC's "Invest Wisely: An Introduction to Mutual Funds". It is available at their website: http://www.sec.gov/investor/pubs/mfperform.htm

Martha Harris Myron CPA CFPr is a Bermudian, a Certified Financial Planner (US licence) practitioner and VP, Personal Financial Services at Bank of Bermuda. She holds a NASD Series 7 licence. Confidential Email can be directed to marthamyron@northrock.bm

The article expresses the opinion of the author alone, and not necessarily that of Bank of Bermuda. This article is for information purposes and does not constitute recommendations to buy or sell investment products or as a promotion for financial plans.