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Mutual Funds
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3 ways to beat bloated fund fees
Smarter marketers of mutual funds, new products and just plain higher interest rates are changing the rules of the game -- to the benefit of investors.
By Timothy Middleton
The future arrives in incremental lurches rather than a seamless progression. We don't use Dick Tracy's wrist-watch communicator because we're still more comfortable with phones. These old habits, this "culture lag," is why roads in the 1920s were still being designed with sharp curves -- easy for slow-moving buggies to navigate but impossible for fast-moving cars, which had replaced buggies a generation earlier.
But the faster you react to change, the better. Many of us investors persist in behaving as if it were 1999. In that high-return era, equities trumped everything. Cash earned so little that today's computer-based portfolio builders don't think of it as a money-making asset class.
Technology will catch up -- though it may take 35 years. Meanwhile, you can make money by marching straight into the new reality. There are three things you can easily do to improve your investment returns:- Consign mutual-fund supermarkets to the dustbin of history.
- Recognize that exchange-traded funds can replace mutual funds.
- Recognize that cash can be a great investment.
In every instance, you'll make more because you'll spend less. Investing is one of the few marketplaces in which otherwise-rational people take pride in overpaying. Who cares what it costs? they say. Returns are what matter.
That is P.T. Barnum talk. Money serves me better when it's in my pocket rather than my broker's.
Not so super
What's wrong with fund supermarkets and their no-transaction-fee networks? They cost too much. Here's why. In the late bull market, mutual funds sprouted like tort lawyers in a field of tobacco dreams. Formerly, funds were few, and choosing among them was simple. Now there are many, and choosing is hard.
Enter the salesman. Marketing became so important to fund companies that they lobbied the Securities and Exchange Commission to create an entirely new kind of fee, called a 12b-1 fee. It's supposed to pay marketing expenses on the theory that when a fund gathers more assets it can lower its other costs. Yeah, right.
Marketing creates middlemen. For funds, it created supermarkets like one run by Charles Schwab & Co. They offer more funds than even the largest fund complexes, meaning you can shop for best-in-class funds very easily.
The supermarkets got so many customers, and so many funds, they realized they could charge for this convenience. The tab at Schwab currently is 0.4% of assets of the funds in the NTF network. One way or another, funds pass that cost along to you. Most funds charge investors 0.25% in 12b-1 fees to pay supermarket costs. The rest comes out of their bloated management fees.
Smart investors don't pay for something that doesn't benefit them. I look for low-fee funds at companies like Vanguard, Fidelity and T. Rowe Price. When I can't find exactly what I want, I use a supermarket -- Schwab, in my case. But I almost never buy a so-called no-transaction-fee fund. Here's an example that shows why:
When I bought an intermediate-term bond fund, I wanted Harbor Bond (HABDX). This is a no-load fund that's been managed since the end of 1987 by Bill Gross, founder of Pimco and manager of the world's biggest actively managed fund, Pimco Total Return (PTTAX). Nobody is better, and there's no better way to hire Gross than through Harbor.
That's because Harbor's expense ratio is 0.6%. It keeps costs down by, among other things, avoiding Schwab's NTF list. The D shares of Pimco Total Return (PTTDX), on the other hand, are in the network. Its expense ratio is 0.75%, of which one-third is a 12b-1 fee.
Can you guess which fund delivers higher returns? In each of the three years ended Aug. 31, Harbor returned 5.96%. Pimco returned 5.62%. The difference of 0.34 percentage points is almost exactly what Schwab charges.
Exchange-traded flexibility
Since the Harbor fund wasn't in the NTF network, I had to pay a commission -- euphemized as a transaction fee -- of $88.87 on about $18,000 worth of fund shares. That's 0.49%, but it's one-time only.
Consider: Schwab charges me $12.95 to trade a similar amount of stock, including ETF shares. There is no ETF that exactly corresponds to Harbor Bond, but one comes close: iShares Lehman Aggregate Bond Fund (AGG, news, msgs). Its expense ratio is a mere 0.2%.
There is a low-cost mutual fund that compares with the Lehman Bond ETF: Vanguard Total Bond Index (VBMFX). It also charges expenses of 0.2%, and its performance is virtually identical with Lehman Agg. I can buy it commission-free from Vanguard, but not from Schwab.
So I've got trade-offs to make if I want to go low cost. On the one hand, I can open accounts with every mutual fund company I ever want to deal with. On the other hand, I can buy ETFs from a single source -- any broker at all, including online brokers that charge only around $7 for a trade.
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There is a catch. So far, ETFs have been limited to index funds. Harbor Bond is actively managed, and I want that. It delivers higher returns than Lehman Agg because Gross is the best guy at what he does in the industry.
By their nature, the institutions that sell ETFs have to be able to convert ETF shares into shares of the underlying companies, on demand. To allow active management, ETFs would also have to be totally transparent, and no fund manager would allow Wall Street to watch his stock buys and sells minute by minute. If they could, why would they bother paying him?
But I expect this limitation to be overcome within a few years. The American Stock Exchange, where ETFs are important listings, is working feverishly on devising a structure that will allow an actively managed fund to trade as an ETF. The Amex needs this business: It will succeed.
When it does, all but the lowest-cost mutual-fund companies will have bull's-eyes on their backs.
Cash, again, is king
I've been talking about bonds because we're in a low-return world now where they are very competitive with stocks. Vanguard Total Bond Index has returned an average of 6.51% in each of the last five years. Vanguard 500 Index (VFINX), which tracks the stock market, has declined 1.62% annually.
And as everyone knows, the Federal Reserve is relentlessly raising interest rates. It's bumped up its federal funds rate 11 times in the last 15 months, to 3.75%. Since cash yields are directly related to that rate, money-market funds and bank certificates of deposit are suddenly very competitive.
Last week's issue of Barron's reported four banks offering at least 4.3% on one-year CDs and 4.75% on five-year certificates. EmigrantDirect.com, a division of the Emigrant Savings Bank in New York, is offering 4% on a money-market account. If you can get guaranteed rates like these, why take the risk of owning bond funds that currently are yielding around 4.25%?
Moreover, the Fed is pledging to continue raising rates to fight inflation. Each bump up hurts bonds but boosts money-market returns. And you don't even need a broker to buy a CD. Banks have lower overhead than mutual funds, and every bank in my neighborhood is advertising CD rates on big placards, sort of like gas stations advertise prices.
(Unfortunately for drivers, the numbers at both are becoming similar.)
You might wonder why, when I recently rejiggered my model portfolio of ETF funds, I didn't capitalize on this fact to own more cash and fewer bonds. The answer: Portfolio management software can't calculate returns on cash. Not just ours at MSN Money. None of the popular programs or web sites has entered the 21st Century in this regard.
But you don't need software to manage your own money. You can keep abreast of the times much more readily than technology can.
Just keep pinching those pennies. In investing, a penny saved, with compounding, is 10 pennies earned.
At the time of publication, Timothy Middleton didn't own any securities mentioned in this article.
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