Wednesday, December 9, 2009

Mutual Funds Explained: Topic of Fees

Mutual fund investing should be a simple process. It should be straightforward and easy to understand. Unfortunately, once we get involved, we bring our own set of behaviors to the process.

In our first discussion about performance comparisons for mutual funds, we looked at the downside of simply comparing side-by-side an actively managed fund with one of the indexes that are published. These indexes span a wide variety of categories in order to help investors understand how the broader market has done in relation to the fund they own.

Trouble is, no fund, not even index funds are able to buy in total, all of the stocks in a particular index. Yet, index funds are designed to come as close to the index they mimic. Any wide discrepancies, either higher than the index or lower than the index should raise a warning sign to current and new investors. This could point to a style drift, a process whereby the fund manager looks to stocks outside the parameters of the index to beef up returns. because in the world of mutual funds, one-hundredth of a percentage point can often sway the investor's decision of which fund to choose.

Often, this focus on returns drives the investor to funds that are the wrong ones for a long-term approach. Even almost five years since the publication of the paper b the Wharton School :"Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds," by Madrian, James J. Choi, professor of finance at Yale, and David Laibson, economics professor at Harvard, folks still do not adequately take these costs into account.

In their experiment, they used index funds as the sole investment. The S&P 500 index, which tracks the 500 largest companies trading on the US exchanges should all have identical returns over the same period. The only difference lies in the fees the fund charges the investor. These fees are often touted as the lowest available and with good reason. The investment itself is passive. Managers buy and hold any underlying stocks in the portfolio until the index itself is readjusted.

Their concern before the experiment was based in the question: why, if index funds outperform actively managed mutual funds most of the time when held over long periods of time, such as twenty years or more, would an investor pay higher fees when index funds charge so much less? They pointed out that when an investor considers fees to relative performance, say when an actively managed fund matches the returns of a passively managed index, the investor will not consider fees as an important factor in the process. If both of the funds in this paragraph earned the same 10% over that twnety years, the difference in real dollars would be over $11,000.

To conduct their experiment, the chose only four funds, all S&P 500 index fund. They all varied slightly in overall fees with the performance of these funds almost identical. They could invest all of the hypothetical $10,000 in one fund, or divide the investment among many funds. The reward for outperforming their cohorts was an actual cash prize: the profits generated by the best performance over the course of a year.

They broke the students in the experiment into three groups: one received a prospectus accompanied by a returns sheet, one a prospectus accompanied by a fee sheet, and the last group, the control group, received only a prospectus. In each case, the prospectus was the same as the one any investor might receive upon request.

The result of the experiment indicated that disclosure did have an effect on the students in all three groups. The group with the returns sheet did the worst. Those that received fee information did better. What was most curious about the results: the students with the fee sheets could clearly see that one fund among the four offered the lowest fees yet not one student put all of their money i that fund despite the relative identical natures of the overall investments.

By no means does this say that fees are or should be the only force in your decision to buy a certain fund. But they should enter into the discussion at a much higher level that that of overall performance.

Next up, the role of the manager.

Paul Petillo is the Managing Editor of

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