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Investing in Mutual Funds
If you do not have the time or expertise to manage your own investments then mutual funds may be your only option, but just understand how much it is costing you:
- up-front (front-end) fees vary between 2% and 8% of your capital (averaging 4% to 4.5%);
- annual management fees (operating expenses) vary between 1% and 2% of capital;
- other hidden fees may amount to as much as another 2% per year;
- some funds may even have exit (back-end) fees as well.
The reason that we invest in equities is two-fold: to receive dividend income and to benefit from price gains. Price gains are a result of expected increases in future dividends (see Warren Buffett v. Dividends); so we could say that the sole reason that we buy stocks is for dividends and future dividend growth.
Now the average dividend yield paid by a stock in the S&P 500 is 2.0% (excluding the +/- 120 stocks that did not pay a dividend -- the average over all stocks is 1.5%). And we can expect dividends to grow at roughly 5.0% per annum above the rate of inflation (in line with GDP growth). So our total return is likely to average around 7.0% over the next decade. We are unlikely to see a repeat of the heady 18% p.a. returns from the dot-com boom of the 1990's.
If a fund has a heavy 2.0% annual management fee, they are taking the entire income during the life of your investment! A 1% annual fee would mean that they are generous enough to leave half of the income from your investment. Compare what your investment capital will be after 20 years with and without fees:
|No Fees||Low Fees||Full Fees|
|Real annual return (net of fees)||7.0%||6.0%||5.5%|
|Future Value of $1000 per month invested for 20 years||$520,000||$462,000||$413,000|
|Future Value of a $100,000 lump sum* invested for 20 years||$387,000||$320,000||$284,000|
Full fees amount to more than $100,000 over a 20 year period! Shop around carefully for the best deal and remember that brokers are going to recommend funds that pay the most commission -- not necessarily the ones that give you the best deal.
No-load funds (low fees) have no up-front fees and significantly lower expense ratios. You would think that high-load funds (full fees) would offer better investment returns but the opposite is often true. No-load funds frequently out-perform their high-load counterparts.
|Why is the number of no-load funds shrinking?|
|Because most investors buy mutual funds through a broker/investment advisor. No-load funds do not pay commissions so they find it difficult to source sufficient funds. There aren't enough astute investors who buy their funds direct.|
Active or Reactive?
Many investors follow active strategies but end up being reactive, rotating in and out of stocks at the wrong time.
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Fund managers or their associate companies also benefit from other hidden income such as underwriting fees, placement fees and commissions.
|Companies undertaking large listings or rights issues face a choice,
The underwriter doesn't carry the entire risk him/herself, like any good bookmaker they lay it off, entering into sub-underwriting agreements with various institutions in return for a share of the fees. All of these institutions control large blocks of investors funds, so it is easy for them to absorb the risk. If they have to take up stock you can be sure that some will end up in your portfolio/managed fund. You carry the risk and they take the fees.
Placement fees are similar except that the investment bank or broker does not underwrite the issue. They merely act as an intermediary between the issuer and the institutional investors; in return for a fee.
Fund managers are often owned by investment banks or institutions that also have a brokerage arm. Brokerage costs are not disclosed as part of the operating expenses of mutual funds, they are hidden from public view. You can be sure, in that case, that the mutual fund pays brokerage commissions at the top rate: more hidden fees.
Fund managers often promote their latest, best-performing fund; whether this be Russia, Afghanistan, Oil or Technology. And the returns look pretty impressive in the short term. Ask yourself two questions:
- Were they promoting this fund 3 or 5 years ago?
- If not, what funds were they promoting 3 or 5 years ago and how well have they performed since then?
A lot of funds perform in cycles and the ones that show the most attractive returns now may deliver the worst returns over the next 5 years. Don't always buy the flavor of the month.
And the funds that were being promoted 5 years ago? They are probably collecting dust at the back of someone's cupboard -- or on the back page of the brochure -- waiting for the next cycle.
It makes sense to only deal with fund managers with integrity:
- look for conflicts of interest - avoid managers who have their own brokerage arm, investment bank or manage hedge funds;
- avoid fund managers who advertise short-term performance; and
- avoid fund managers who do not close off funds when they reach a reasonable size - those who don't are chasing fees, not performance; and
- avoid fund managers who charge excessive front-end or annual fees.