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Fund Fee Primer

February 26, 2007

Front-end loads, back-end loads, expense ratios, management fees, redemption fees, 12b-1s. If you're confused by all the fees associated with mutual fund investing, you're not alone. But since the amount you pay to your mutual fund company can make a huge difference to your long-term returns, getting fee-wise is something all fund investors need to do. Doug Roberts at bloggingstocks makes you a little smarter with this brief intro.

There are two types of mutual fund fees and expenses -- the single shots and those that are ongoing. The single shots generally consist of one-time charges, like sales fees and redemption fees.

Sales fees or commissions, often referred to as a "sales load," may be charged when you enter the fund (front-end) and when you exit it (back-end). They are usually paid to the mutual fund company, the broker or salesman.

I strongly urge you to avoid investing in funds that charge a sales commission. When a sales commission is charged, possibly 4% to 5%, this means that you must outperform a similar fund without a commission by that amount just to match its performance. This is usually not an easy task. Furthermore, a sales load locks you into the fund. You need to stay in it for a long time to cover this cost and still get a competitive rate of return. When a commission is charged, you never know if your broker or advisor is favoring the fund that is best for you, or the one he stands to profit from the most. Often, if you do some detective work, you can find a similar fund without the commission, sometimes with the same manager.

Redemption fees usually refer to fees charged for early redemption in order to discourage short-term trading and "market timing." These fees are not bad for the long-term investor, as long as they are reinvested into the fund and not pocketed by the fund managers, brokers or salesmen.

With redemption fees, the key is to ensure that the fee is paid to the mutual fund itself. In general, I prefer funds that do not extend their redemption fees longer than three to six months, unless they offer superior performance for their category with a very low expense ratio.

In addition to these one-time charges, there are ongoing fees that are charged every year and impact the performance of the fund, even for the long-term investor. These include the expense ratio and brokerage costs.

The expense ratio is the total annual expenses of the fund, expressed as a percent of assets in the fund. It includes the management fee paid to the mutual fund manager, operating and administrative fees paid to run the fund, and 12b-1 fees used to market and distribute the fund. The general rule with expense ratios is "The lower the better." New funds sometimes have high expense ratios because of their small size. These funds should make every attempt to lower the expense ratio as they grow. This indicates a cost-conscious environment and a desire to put shareholders first."

Diligent fund investors need to look for (and avoid) level loads as well as front and back end loads. Level loads are 12b-1 fees in excess of 0.25% per year. Funds with such ongoing sales commissions will be categorized as "LOAD" on our website (red LOAD graphic) and will not come up in screens if you exclude load funds - even though these funds have no front or back end load


See also:

A Fund Fee We Love
The Worst Mutual Fund Investing Advice Ever
Are You Paying A Sales Load?

Past Isn't Prologue

February 24, 2007

How about a Saturday reminder, via Blodget at Slate, not to invest in a mutual fund based on its past performance?

Most investors have heard the "past performance" warnings before, but like other common mantras, do not heed them. Why not? Because they defy common sense. Above-average fund managers should have beaten the market, while below-average ones should have lagged it. So, all we need to do, the logic goes, is to look at some past performance—and pick a few managers who have put the market to shame.

The first of many reasons why this logic is flawed is that excellent past performance is often the result of something other than skill—namely, chance. In any given period, a random selection of stocks will beat the market about half the time. Similarly, a random selection of fund managers will beat the market about half the time (before costs). As a result, the difference between a supertalented fund manager and an average one is often as hard to discern as the difference between a .350 hitter and a .280 hitter in baseball. Over many seasons, with the help of detailed statistics, the difference is obvious. Over a few dozen at-bats, however, the hitters often look about the same.

Second, strong past performance is often the result of the temporary dominance of a particular investment style: growth stocks in the late 1990s, for example, or value stocks and small stocks from 2000 to 2006, etc. When a particular fund manager's style is in vogue, the fund can post extraordinary returns. These returns can disappear quickly when the market environment changes, however. (If you could predict the future, you could theoretically switch from style to style, but the whole problem with stock-picking, market-timing, etc., is that most people aren't Nostradamus.)

Third, even if you do manage to find a fund whose excellent past performance is the result of skill, something critical to the performance might soon change—leaving you with a frightfully ordinary fund (and facing a big transaction and tax hit if you decide to ditch it)."


Why do we post so many articles warning against the dangers of relying on past performance to make mutual fund investing decisions? Because, believe it or not, past performance is still the number one factor mutual fund investors consider when making buying decisions.

What Not To Do

February 23, 2007

Marshall Loeb provides the list of five big mistakes mutual fund investors make. We provide the commentary.

  1. Chasing performance - Don't buy last year's hot funds. Studies show that funds that are currently at the top of the performance heap have less of a chance of beating the average fund return going forward than funds that did less well.
  2. Paying commission - Don't pay loads. Ever. There are perfectly good no-load alternatives for each fund that charges you 5.75% of your money for the privilege of investing in it.
  3. Paying excessive fund expenses - When it comes to fund expenses, the cheaper the better. Fund expenses eat away at your returns. It's usually the cheapest funds that make you the most money long-term.
  4. Buying funds with high turnover ratios - A high turnover ratio is generally bad for a fund to have because excessive trading produces larger commission fee expenses, higher income and capital gains distributions, and might imply a lack of a clear investing focus by the fund manager. The industry average turnover ratio is 102%. We generally prefer funds that don't exceed 65%.
  5. Having inadequate diversification - Basically, the idea behind diversification is to spread your money among many different investments as the chances of them all going bad at once is pretty remote. Purchasing even a single mutual fund automatically provides a certain level of diversification by taking your money and investing it across all the stocks and bonds the fund owns. The problem is that many mutual funds invest in a single sector or country - technology stocks, financial companies, or Chinese equities, for example - and very often all the companies in a particular sector or industry rise or fall together. Therefore, your best bet is to buy a few different funds that concentrate in entirely different fund categories. And, depending on your risk profile, it is also a good idea to keep a certain percentage of your money in bonds and some in cash.


You can check a fund's performance history, expense ratio, turnover ratio, and whether or not it is a load fund or a no-load fund, by entering its ticker into the Fund-o-Matic. (MAXfunds.com is also the only place where you can instantly compare a fund’s expenses to similar funds INCLUDING an adjustment for hidden portfolio-level expenses resulting from trading. Check each fund's MAXrating: Expenses for the complete expense picture.)

See also: MAXuniversity Part III - MAXfunds.com's Seven Rules of Mutual Fund Investing.

Some Gold Fund Managers Wary of Buying Gold

February 22, 2007

Looks like some gold fund managers are as pessimistic as we are about the yellow metal. Many are hording much of the cash that performance chasing investors threw at them after gold fund's hot run of the last few years.

With gold headed back toward its highest level in decades, why are so many gold fund managers holding so much cash?

Take Frank Holmes, chief investment officer at U.S. Global Investors in San Antonio. His $250 million Gold Shares (USERX) held 16.4% in cash as of Dec. 31, while the $1 billion World Precious Minerals (UNWPX) had 14.5% of its assets in cash at year's end.

While it might seem like a fund with that much money on the sidelines would have missed out on gold's rally of 20% from its low of around $560 an ounce last October, Holmes says it has provided much needed flexibility.

"What happens is that when the stocks really get clobbered, I have the money to buy them," the fund manager says.

Another reason for big cash sake is that hot money fund investors are just as quick to turn tail when gold loses some luster. The manager of a fund inundated with hot money typically has to keep cash around to meet fast liquidations – otherwise the manager would have to sell fund investments which increases fund turnover and trading commissions and other costs. US Global Investors World Precious Minerals (UNWPX) fund currently has a hot money of 5 (the worst).

This needed cash cushion is one reason funds with high hot money ratings tend to under-perform going forward. Hot money in these funds in general is the main reason why our current category rating for precious metals funds is just 25 out of 100 (poor).


Our Favorite precious metals funds:

Think Outside the 401(k)

February 21, 2007

One thing we've learned while reviewing client's 401(k) plans for our MAXadvisor 401(k) Planner service: a lot of 401(k) plans are really lousy. Some offer only expensive or otherwise poor mutual fund options. Other plans lack variety, making it tough to build a well diversified portfolio. What do you do if you need small-cap exposure, but the small-cap choices in your 401(k) are either terrible or non-existent?

A common mistake people make is to balance their 401(k) and to make certain it's diversified among various asset classes," says Gary Schatsky, an attorney, CPA and former chairman of the National Association of Personal Financial Advisors. "It does not need to be balanced. Your investments do."

That means if you have some money to invest outside your 401(k), you can put it to work in the foreign stock fund of your choice and use the money inside your 401(k) plan to get exposure to other asset classes.

Ideally, you can purchase the investments that aren't available in your 401(k) through another kind of tax-deferred account, such as an individual retirement account, to maximize the effect of compounding returns."

And if you decide you need to look outside your 401(k) to build a properly diversified portfolio, a little forethought can save you a bundle in taxes:

One thing to keep in mind when you're looking at your total portfolio is that different kinds of investment returns are taxed at different rates. Interest and short-term capital gains are taxed at rates as high as 35%, depending on an investor's income. But most investors pay 15% on qualified dividends and on long-term capital gains, or the appreciation on an investment held for more than a year.

So it makes sense to put investments that generate the biggest tax bills, such as taxable bond funds or funds that turn over their stock holdings frequently, in tax-deferred accounts.


See also: Ask MAX: Should I Invest in a Loaded 401(k)?

Diversify, Don't Di-worsify

February 20, 2007

Good advice from Dan Hallett at Morningstar Canada:

To some extent, holding two or more similarly managed funds holding like but not identical stocks (i.e. large cap Canadian) could be considered simply as an exercise in diversification, but it doesn't take long before portfolio dilution (or "di-worsification") kicks in. This is where the portfolio risks becoming more index-like but with active management fees. That will doom any portfolio to long-term underperformance.

The industry's bloated line-up of products is to blame. If we look at the entire fund industry as one gigantic portfolio, Canadians are holding hundreds and hundreds of unique funds just to invest in Canadian stocks. I would never recommend that any investor spread money among hundreds of funds -- particularly in such a small asset class. And I have opined in the past that at least 90% of funds are probably not worthy of investors' dollars. Accordingly, investors in aggregate are bound to underperform.

Diversification is a critical component of sound portfolio construction. Investors must strike the delicate balance of having sufficient diversification (to reduce reliance on any one stock) with the need to stay focused enough to make active management worth paying for. Dilution (or excessive diversification) can result in an expensive, index-like portfolio. Too focused a portfolio can incur too much risk (making success more uncertain)."

See also:

Ask MAX: Should I Listen to my Neighbor?

Fidelity is Having A Bad Year

February 19, 2007

A tough year at Fidelity has Kiplinger.com's Steven Goldberg wondering if the overhaul of stockpicking operations that the mutual fund giant undertook a year and a half ago might need some serious tweaking.

I don't think the wheels are falling off at Fidelity. But plainly some mid-course corrections are in order for the huge revamping of the stockpicking operation that Fidelity launched 18 months ago. Someone high up at Fidelity may -- or may not -- agree. Stephen Jonas, who headed that restructuring, retired at the end of January. Bob Reynolds, Fidelity's chief operating officer, says Jonas, 53, wanted to spend more time with his family and that he and Jonas "came to a mutual agreement that this was a good jumping off point. Performance had nothing to do with it." Maybe so.

Longer-term performance at Fidelity hasn't been awful, but those of us old enough to remember when Peter Lynch turned Fidelity Magellan into the most famous fund in the land do long for the good old days. Over the past three, five and ten years, Fidelity's average U.S. diversified fund ranks above average -- in the 40th to 42nd percentile over each period. The trend at Fidelity's foreign funds has been disturbing. Over the past ten years, they're in the top 32% of diversified overseas funds. Over the past five years, they're in the top 40%. But over the past three years, they rank in the 73rd percentile (or the bottom 27%)."

Despite the rough patch, we still include several Fidelity funds in our MAXadvisor Powerfund Portfolios' Our Favorite Funds report. Fidelity Small Cap Growth (FCPGX) makes the cut in the small cap growth category. Fidelity Europe Capital (FECAX), Fidelity Southeast Asia (FSEAX), Fidelity Global Balanced (FGBLX), and Fidelity Spartan International (FSIIX) also get gold stars.

Let’s Hear it for the Good Old IRA!

February 18, 2007

Tom Sullivan reminds us that in a world where 401(k)s are getting all the press, we shouldn't forget about the grand old man of retirement vehicles, the individual retirement account.

Survey after survey shows a heavy majority of people say they will not have enough to live on when they retire. Yet less than half of them say they are putting money into an IRA. Why not? The clock is ticking, and the day of reckoning is coming.

You do not have to contribute money in one lump sum, nor do you have to contribute the maximum amount allowed.

You can put in as little as you want, a tiny amount, if that is all you can afford. You just cannot exceed the annual maximum, which is now $4,000 (or $5,000 for people 50 or older). You can budget it to make a monthly contribution, if that makes it easier on your checkbook.

Don't let the rules on tax deductions sway you against contributing. Many people won't contribute because they don't qualify for a tax deduction. They may already be in another qualified retirement plan, their income is above the deduction threshold or they chose a Roth IRA.

(The Roth IRA, you may recall, is not tax deductible, but all earnings are completely tax-free.)

A tax deduction should not be the main reason you consider putting money into an IRA. You are saving money, and it grows without any current tax liability. The idea is to build a nest egg for the future.

People often ask me whether they can contribute to both an IRA and a 401(k). Yes, you can put money into both."


Actively Managed ETFs

February 17, 2007

The ETF craze may kick into overdrive now that the SEC is seriously considering allowing actively managed exchange traded funds - to heck with the front running issues.

While ETFs bring in a good chunk of all the new money going into funds these days, ETFs have been based on an index or basket of underlying. Most ordinary mutual funds are actively managed, meaning that fund managers decide which stocks to buy rather than simply investing in whatever is in, say, the S&P500 Index. That could soon change.

Many industry observers have predicted 2007 would be the year the ETF marketplace sees its first truly actively managed products. The earliest ETFs tracked recognizable, plain-vanilla indexes such as the S&P 500.

However, more firms entering the ETF business are launching products on increasingly complex indexes that, arguably, already incorporate elements of active portfolio management. "

One thing is for sure, we'll see ETFs with higher fees once "expert" management comes into play.


MAXadvisor Powerfund Portfolios Update

February 17, 2007

Note to subscribers of the MAXadvisor Powerfund Portfolios: this month's portfolio performance data update and commentary has been posted. Subscribers can log in by clicking here.

The MAXadvisor Powerfund Portfolios is a collection of seven model mutual fund portfolios ranging in risk from very safe to quite aggressive. Each portfolio is made up of a group of terrific, no-load, low-cost mutual funds that are carefully chosen to work together to lower volatility and increase returns. You can learn more about the MAXadvisor Powerfund Portfolios (and sign up for a free trial if you like what you see) by clicking here.