Do you know how much your mutual fund is costing you?
"The costs of actively managed funds are higher than most investors realize," says an article in the respected newsmagazine The Economist.
"Everyone knows that if you go to a casino, the odds are rigged in favour of the house. But people still dream of making a killing.
"The same psychology seems to apply to fund management, where investors flock to high-cost mutual funds even though the odds are against them."
Example: Invest $3,000 every six months in two funds. One fund produces an average annual return of seven per cent - compared with the other fund's sixper-cent net return because of a variety of extra costs. At the end of 30 years, you would have $589,551 in the cheaper fund compared with only $489,159 in the more expensive fund.
Interestingly, that 20-per-cent difference is the same figure calculated by Bill Sharpe, a Nobel laureate in economics, when he compared the effects of investment management fees on an investor's standard of living in retirement.
Top fund managers or the best asset allocation could certainly outperform passive funds invested in the stock index - but almost nobody can consistently choose those outperforming funds. The Economist cites the various costs that eat into the investor's net return:
- Investment management fees - you have to pay the higher costs of an actively managed fund, compared with a passive index-linked fund.
- Trading costs - active management means buying and selling securities. n The cost of holding cash while waiting for buying opportunities - indexlinked funds are usually fully invested.
- Sales costs - although front-end loads are less common these days, the advisor or broker still collects a fee in one form or another.
- Tax costs - you must pay the tax on capital gains realized each year rather than allowing the full gains to compound over the long term.
"Add these costs together and the net return to investors may be reduced by 2.66 percentage points a year - a huge differential considering long-term real returns from equities have been 6.45 per cent," said The Economist.
Mike Grenby is a columnist and independent personal financial advisor; he'll answer questions in this column as space allows but cannot reply personally. Email [email protected].
