Is that mutual fund overpriced?

Source: MARKETWATCH

Commentary: How to tell when a funds costs are too high

By Chuck Jaffe, MarketWatch

Last Update: 12:42 PM ET Apr 15, 2013

Are your mutual funds worth what you are paying to own them?

Most investors answer that crucial question backwards, saying that the funds results either do or do not justify the money the percentage that management keeps for itself.

The problem is that investors should answer that question looking forward, and try to come up with the reasons they believe the manager can justify his or her paycheck.

What makes that hard to do is that most investors dont have a good idea of what is reasonable to pay for a mutual fund.

The Investment Company Institute the fund industrys trade association came out this week with its annual look at fund expenses, crowing about how the trend in recent years has been going in the right direction.

Indeed, while fund ownership, on average, costs less than in the past and while the statistics show that investors tend to concentrate on issues with low costs few fund buyers properly factor costs into the buying equation.

Costs matter because they are the one thing that an investor can count on; returns, by comparison, will vary, but management takes its cut regardless. So if a large-cap growth fund is up 8% in a year and charges the average expense ratio for the category 1.27%, according to Morningstar Inc. the fund is going to be up 6.73% for the year, the gross return for the fund minus its cost.

Money, however, typically flows into lower-cost funds. The dollar-weighted average expense ratio for large-cap growth funds the average paid by investors who own funds in the category is 0.80 percent, according to Morningstar. That means that if the fund can generate a gross return of 8%, their return from the fund will be 7.2%

That difference adds up over time. If the market averaged that return each year over 10 years, the investor in the fund with the lower expense ratio would double their money, while the one facing higher costs will come up about 5% short of that.

Thats why some investors are so adamant about owning low-cost funds that they let the means the ongoing costs justify the ends, namely whatever the fund delivers.

But low costs simply mean that shareholders will keep more of what the fund earns in the marketplace; they dont guarantee great returns.

And thats why another sub-set of investors expects the ends to justify the means, ignoring costs with the expectation of superior returns. Indeed, you could argue that kind of thinking is what drives the hedge-fund world, where the standard fee is 2%, plus 20% of the profits, a lot higher than the average mutual fund, but where investors are expecting higher returns than they could get in traditional vehicles.

Part of the problem is that while average expense ratios are going down, most investors dont know how to measure if a funds costs are high or low.

According to Morningstar Inc., the average stock fund regardless of type charges 1.36% for expenses, while the average bond fund prices out at 0.99%. The dollar-weighted averages which show what the typical investor is actually paying are 0.76% for equity funds and 0.61% in bond funds.

Depending on the assets the fund buys and some of the techniques/difficulties involved in trading those securities the average costs range from 0.75% for near-term (2011-2015) target-date funds to 2.53% for managed futures funds.

The real question, regardless of the asset category, however, is Do I expect this fund to deliver returns superior to an appropriate index fund?

The question shouldnt be Whats the expense? so much as What are the reasonable expectations for the fund beyond its benchmark, said David Trainer, president of New Constructs Inc., a Nashville-based stock and fund research firm. If the incremental expense above and beyond what you would pay for the index is not justified by the returns you expect the fund to deliver, then its not worth paying up for the fund.

And if you think the fund can deliver the extra return but, going forward, it doesnt, you have good reason to be disappointed with the fund.

There are reasons to pay up for a fund; perhaps you like a manager of a small start-up fund, where the issue has yet to garner enough assets to cut costs. Or maybe you want to pursue a more esoteric investment strategy.

The average long-short equity fund, for example, carries an expense ratio of 2.04%; the average investor in those funds is paying 1.29%, which means they are gravitating toward cheaper options but they are still paying more than if they used a more-conventional fund type.

Even in something as common as small-cap growth where the average fund charges 1.47%, and the typical investor is paying 0.98%.

By knowing the average expense ratio and what the typical investor pays you can decide whether you really believe the funds potential is worth any premium you might be paying.

Said Trainer: A fund that charges more than average has to be able to convince you its worth it, and it has to do that before you buy it. It doesnt make a difference that expense ratios are coming down, if youre not getting what you are paying for from your funds.

Judging the cost of a fund

Fund type Average Expense Ratio* Asset-Weighted Expense Ratio*
US Equity 1.27 0.69
Intl Equity 1.49 0.90
Balanced 1.27 0.79
Alternative 1.98 1.40
Taxable Bond 1.01 0.61
Municipal Bond 0.95 0.59
All Equity 1.36 0.76
All Bond 0.99 0.61
All Funds 1.27 0.72

* based on the most-recently reported expense ratios

Source: Morningstar

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