12. How to Pick Mutual Funds: Bargain Shop

It’s enough to drive a control freak crazy.

You can’t control the stock market as it goes through unpredictable cycles. There’s no way to know which mutual funds will be outstanding or disappointing in the years ahead. The most acclaimed investing stars in the mutual fund business tend to fizzle with time.

Those realities might be making you feel a little out of control at this point, perhaps wondering just what power you have over your money.

You actually have quite a bit—just not the type people imagine when they think their future depends on picking a hot stock or a top mutual fund. Remember, asset allocation—or mixing and matching categories of mutual funds—sets you up to grow your money well if you’ve matched the ingredients in your recipe diligently.

But beyond that, you can control one other factor as an investor. And you should, because it’s the one “sure thing” you can count on to make a huge difference in the money you will accumulate over a lifetime.

I’m talking about fees, or the expenses you pay when you invest. You might not know that you are paying anything; most people don’t realize it. But whenever you buy a stock, a bond, or a mutual fund, you pay fees, and costs vary greatly. If you don’t pay attention to them, they will rob you of the easy money you could make—not just nickels and dimes, but thousands of dollars.

Suppose that you are 22 and you invest $1,000 for 40 years in a mutual fund that keeps your expenses low. If your fund averages 8 percent annually after you’ve paid all the expenses, in 40 years, your $1,000 will have become about $21,700. Contrast that with a high-priced fund, charging you only 2 percent extra in expenses over the low-cost fund. In 40 years, you will have only about $10,300, or just half as much as you could have if you’d been attentive to fees.

To most people, the costs they pay for their mutual funds are invisible. If you have money in a mutual fund now, the fund company is removing fees automatically from the money you have invested. When you pay the fund company, the money goes toward everything from the fund manager’s salary to advertising costs. That’s right; you pay the fund company to lure potential new investors. You pay fees whether the fund makes you rich or loses your money.

It’s all part of the deal, the way the fund industry operates. But fees also differ significantly between funds, so you can save yourself a bundle if you just notice two simple numbers: the expense ratio and loads. Don’t get nervous over the math-sounding word ratio. You don’t have to do any math, and being aware of these two numbers takes less than a minute of attention—yet it can save you thousands of dollars over a lifetime of investing.

I explain more about how to do it later. For now, I just want you to understand the control you have over the fees you pay. When you see a fund charging you 0.18 percent, you have found a good deal. When you see another charging 2 percent, you need to be on guard.

Tiny Percents Have a Huge Impact

Although 0.18 percent and 2 percent sound like tiny, insignificant numbers, the difference between them ends up being gigantic over time. That’s because of the power of compounding, which you can review again in Chapter 2, “Know What You’ll Need.” Compounding helps your money grow, and the more money you have invested, the more it can grow. When you give up money by paying unnecessary fees day after day, it sets you back for life. Every year that you pay an extra percent, you reduce the money you earn that year and every other year afterward—you rob your nest egg forever.

Let me illustrate this using some research done by Edward O’Neal, a professor at Wake Forest University. O’Neal examined 5,000 mutual funds in 2004 and determined that the average fund then was charging investors 1.41 percent a year on their money.

In other words, if you had $10,000 in the average mutual fund, you were paying $141 a year in fees. That doesn’t sound so bad. But consider the alternative: You can get funds that charge just 0.10 percent, or about $10. You tell me, if you went into a store and saw two identical shirts, one for $141 and one for $10, which would you buy?

In his study, O’Neal took a modest approach, focusing on the low-cost funds charging an average of 0.314 percent, or about $31. If you chose one of those low-cost funds and invested $10,000, and the investment earned 10 percent annually, you would have about $63,200 in 20 years. If you instead held on to the fund charging 1.4 percent and earned the same 10 percent return on the investments, fees would shortchange your future by more than $12,000. You would have only about $51,000.

It has always shocked me that people will drive for miles across town to save $50 on some household item but will throw away thousands on their mutual funds without giving it a second thought. I think they do this because numbers such as 1 percent sound so small and because mutual funds are so confusing that people just want to get the job done.

Mind Your Money: Your Broker Might Not

Also, brokers and many of the mutual fund companies have no incentive to tell clients that they are paying more than they need to pay for their mutual funds. The higher your fees and commissions, the more money the fund companies make, and the more the brokers make.

Talk about a conflict of interest: If the broker sells you what’s best for you, it very well might hurt him by reducing his compensation.

Controlling costs is easy. And here’s what might shock you: Cheaper funds generally do better than those that charge you more.

You might find that surprising because, as consumers, we generally are taught that “you get what you pay for.” Some financial advisers use that line to justify the exorbitant fees they charge clients. But the assertion simply is not true when it comes to investing in mutual funds.

Cheap Funds Work

Morningstar, known for its mutual fund research, has studied fees in depth. The firm’s director of research, Russel Kinnel, says, “Each move up in price greatly lowers the likelihood that a given fund will be able to beat a corresponding low-cost index fund.”

Index funds generally are the cheapest funds, and I explain more about why you should use them in the next chapter. For now, I just want you to understand why you should not be led astray by sales pitches for expensive funds.

According to the Morningstar study, if you have money in a fund that charges you more than 1 percent, you probably won’t even keep up with the cheapest funds you could have bought. So you are throwing money away. Your expensive fund has only a one-in-seven chance of doing as well as the cheap fund.

Why does this happen? Because investing money is difficult, even for the top fund managers. I’ve talked with many of the nation’s pros, and they are thrilled if they can generate a return for you that’s even 1 percent higher than the stock market as a whole. Because it’s so tough to do, fund managers who do beat the competition, even by a little, get paid bonuses.

So realize when you buy a fund that a half of a percent (0.50 percent) is a big number in the fund industry. If a fund manager excels by even that much, he or she might earn a bonus for outstanding performance. It’s also enough to take thousands from your nest egg, and paying it doesn’t necessarily get you anywhere.

Let’s say that you have a mutual fund that has an excellent year, with a return of 11 percent on the stocks in the fund. During the same year, another mutual fund has a return of only 10.5 percent on its stocks. Your fund manager is superior—at least, that year. But the fund is outstanding only before your fees come out. Let’s say that your fund charges you 1.5 percent of your assets. In other words, your return dips from the 11 percent you would have earned on the stocks in the portfolio to just 9.5 percent after paying your fees. And if the fund that earned 10.5 percent on the stocks charges investors only 0.50 percent, that fund turns out to be a better deal after the fees are paid. The fund’s return, or the money the investor gets after fees, is 10 percent.

The bottom line: A clever fund manager who picks stocks and bonds skillfully might end up doing you little good if a fund is gouging you on fees.

It gets worse. Morningstar has found that funds that charge high fees also take exceptional risks with your money, apparently to try to boost returns to overcome the effects of the fees. It doesn’t work, and it puts you in danger of losing more money than other funds do, on average, according to the research.

So here’s a no-brainer strategy: To stretch each dollar you invest as far as possible, try to select low-cost mutual funds.

Watch Out for Loads

First, try to avoid paying loads, which are nothing more than a fee you pay a broker or financial adviser to select funds for you. Instead, select no-load funds—in other words, they don’t charge you for advice.

If you pay a load, it works like this: Say that you are putting $10,000 into a mutual fund with a 5.75 percent load. That means that you give your broker $10,000, and she keeps $575 of the money as her commission and puts the remaining $9,425 of your money into a mutual fund for you.

Instead of earning a return on your hard-earned $10,000, you earn it on only $9,425. The result: Compounding works on $575 less than what you intended to invest. So over 35 years, if you average a 10 percent annual return, you end up with about $265,000. Not bad. But it could have been about $16,000 more if that $575 had gone into the fund originally.

Try the calculation yourself on your own loads using a cost comparison calculator at www.sec.gov/investor/tools/mfcc/holding-period.htm. Perhaps an easier calculator is www.dinkytown.net/java/FundExpense.html. To look at loads at the Dinkytown site, insert the sales charge (or load) and add no operating expenses to the calculation. It’s easy and takes half a minute. You will probably be shocked by the impact.

Most mutual funds sold by brokers and many financial planners include either conspicuous or inconspicuous loads. Be aware of this so that if a broker assures you that you aren’t paying anything up front in fees, you also realize what you will pay later—perhaps what’s called a back-end load. Many funds that don’t charge you up front (or front-end loads) end up costing you more because they charge you a lot for operating your fund year after year.

To protect yourself, you can ask a broker to show you all fees, loads, and mutual fund expenses you will pay, and ask him or her to do the math for you, showing you what you will pay and what that will do to your earnings over a lifetime of investing. This calculation should include both loads and what’s called the expense ratio. When you have the figures, you can also plug them into the calculators I mentioned previously.

Your broker won’t be eager to talk about fees and commissions because they are the bread and butter of the profession. But you are entitled to know the information, and you can ask to receive it in writing.

Also, to avoid loads, you can skip a broker, take your money directly to a mutual fund company, and buy what are called no-load funds. These funds do not charge you for a broker’s advice. To buy funds directly, you call a mutual fund’s toll-free telephone number and say that you want to put money in a certain fund.

Even if you buy no-load funds directly from a mutual fund company, you still have expenses and must pay attention to them. It’s easy to examine them without doing any math. Aside from loads, everything you pay is blended into one number, called the expense ratio. It sounds like a complicated term, but it isn’t. You will spot it in the materials, or the prospectus, you are given when you buy a fund; you also can get it from the telephone staff at your fund’s toll-free number or ask a financial adviser to point it out to you.

Every fund charges you to pay for the manager of your fund, the paperwork for running your fund, and even the fund’s advertising. All those expenses are bundled together and reported in the expense ratio. Examining that one number alone shows you what percent of your money goes to pay all your various costs.

Whenever you buy a fund, take a quick look at that one number. If the expense ratio is 1.41 percent, you have average costs. With $10,000 in the fund, it means you will pay $141 a year for the privilege of being an investor.

Although that’s the industry average, most investors are paying less because many of the largest mutual fund companies have reduced fees. The ordinary investor pays about 0.77 percent for U.S. stock funds, according to Morningstar’s Kinnel. For international funds, the average is 0.97 percent, or $97. For bond funds, expenses average 0.64 percent, or $64.

Generally, there’s no reason to pay more than those numbers, Kinnel says. And some fine U.S. stock funds, called index funds, charge only 0.18 percent, or $18. Contrast that with some of the higher-priced funds at 2.5 percent, or $250.

To see the impact, go back to the mutual fund expense calculator at www.dinkytown.com that I mentioned previously. Let’s assume that you put $10,000 into a fund with no sales charge or load and an expense ratio of 0.18 percent. (The Web site uses the phrase “operating expenses” for the expense ratio.) Over 35 years, your investments average a 10 percent annual return. You end up with about $264,000. But along the way, you had to pay about $5,000 in total fees as your cost of doing business with the mutual fund. If you hadn’t had to pay anything, you would have ended up with about $281,000 because each penny would have been earning a return for you.

Still, $264,000 isn’t bad at all. Now let’s assume that you paid 2.5 percent every year after making your original $10,000 investment. You would end up with only about $116,000 after paying $40,000 in fees. But you would have lost a lot more than the $40,000 in fees. By paying the fees, you slashed the opportunity to have compounding work on more of your money. Losing that opportunity cost you $125,000. With 2 percent in fees, you would have ended up with about $138,500 after 35 years and missed the opportunity to make another $106,200.

So there you have it. As an investor, you should know that you can’t do anything to foresee cycles in the market. A bet on even the best fund can go terribly off course. But you do have control—a lot of it. And it’s easy. Just examine two numbers: the expense ratio (or operating expenses) and the load (or sales charge), and you will probably make more money than people who think that finding a phenomenal fund manager will make them rich.

I offer you two warnings, however: First, if you are going to procrastinate about investing unless you go to a financial consultant for some hand-holding, then go, and get the help and pay the fees. If brokers are conscientious, they might offer American funds, a group of relatively attractive funds that charge loads but keep costs fairly low. Just stay in the game by asking your broker about fees. And make sure you understand the conflicts of interest that the broker might have as he makes trade-offs between your need to build a nest egg and his need to boost his pay.

Realize that if the broker or financial consultant depends on commissions, he is probably going to tell you that the funds I discuss in the next chapter, index funds, are no good. It isn’t that they’re no good for you; it’s that they’re no good for the broker’s income. And if you try to talk to a broker about finding investments with low fees and he tells you he offers something better, pick up a recent study done by Harvard economist Sendhil Mullainathan and MIT Sloan School professor Antoinette Schoar. They wanted to find out if brokers would do what was best for clients, so they had 300 actors pretend to be clients. These people went to banks, independent brokerage firms, and investment advisory firms in the Boston area and met with brokers or financial consultants.

When the “clients” showed the brokers their low-cost funds and asked for advice, 85 percent of the time, the brokers advised them to dump the low-cost funds and buy more expensive alternatives. Those alternatives would help the broker make money while zapping the clients’ future of thousands of dollars. To help protect yourself, refer to the final chapter of this book so that you get good advice instead of wasting money on high-priced funds.