It's no secret that it costs money to invest in mutual funds. What many people don't know is that expenses can vary greatly among funds, even when the funds are generally similar. High costs can eat away at your net investment returns over time—and that means it pays to shop around.
You should choose a fund based on your financial goals, time horizon, and tolerance for risk. It's equally important to keep an eye on expenses. Princeton University economics professor and former Vanguard® board member Burton Malkiel recommends that investors look for funds with:
- Expense ratios of 0.50% or less.
- Turnover ratios of less than 50%.
- No sales charges.
Get to know your expenses Generally speaking, mutual fund expenses can be summarized as follows:
Expense ratios. Every fund has an expense ratio. This is money deducted from a fund's earnings and assets to pay for annual operating expenses, including investment advisory fees, legal and accounting services, postage, printing, and telephone service. In 2006, the mutual fund industry average expense ratio was 1.27%, while the average expense ratio for Vanguard funds was 0.21%.
Sales charges. Some funds charge a sales fee either when you buy shares of a mutual fund (a front-end load) or when you sell shares (a back-end load). Other funds charge a level load, which you pay annually. Many funds, including all those offered by Vanguard, have no sales charges.
Trading costs. Still another expense is the cost of trading securities, including charges such as brokerage commissions. These costs aren't included in a fund's expense ratio, but they do reduce the returns you receive. A high turnover ratio can cost an investor in two ways:
1. Trading generates brokerage commissions, which can subtract up to 3% from a fund's return.
2. If you're investing in a taxable account, a fund with a high turnover ratio may generate higher taxable capital gains. You may owe taxes on those gains on April 15.
Sneak a peek at the impact of costs. Let's say you have $25,000 to invest. Fund A has an expense ratio of 1.27% and Fund B has an expense ratio of only 0.21%. It may not seem like a big difference, but over time the impact of the higher expenses is significant.
Assuming an 8% rate of return for both funds, here's what could happen to two identical investments over 20 years. This hypothetical illustration does not represent the return or expense ratio of any particular investment.
In sum, investing in Fund A could cost you $20,100. If you're still not convinced that mutual fund costs really do matter, ask yourself whether you'd turn your back on more than $20,000. And don't forget, additional expenses can cost you even more.
Article source: http://www.vanguard.com/ |
