As Ben Franklin said, a penny saved is a penny earned. And with today’s topsy-turvy market and with fees and expenses playing an important role in the long-term accumulation of wealth, the saying is still apt.
Risk and return are our primary tools for evaluating mutual fund investments or potential additions to our portfolio. But, we must also consider the three major drags on fund performance: loads, expenses, and taxes, which can have a significant impact on our returns over the long haul. When we compare funds within specific classifications, we usually see that funds with larger drags on performance underperform their counterparts over the long term—knowledge we can use to our benefit. In a Lipper report entitled Taxes in the Mutual Fund Industry the average front-end load sector equity fund lost 21.6% of its average annualized ten-year gross return to expenses, 7.7% to loads, and 16.7% to pre-liquidation taxes, meaning the average sector equity fund retained only 54% of its gross return after accounting for load, expenses, and taxes. How can we limit these drags on performance?
Figure 1 Breakdown of Gross Return—Sector Equity Front-End Load Funds Based on Pre-Liquidation Annualized Total Return for the Ten-Year Period Ended 12/31/2009
Fees and Expenses
Running a mutual fund involves costs. A fund’s total expense ratio comprises management fees, 12b-1 fees (distribution and/or service fees), and other expenses (custodial, legal and accounting, transfer agent, and other administrative expenses). Total expense ratios can range from a few basis points (for passively managed index funds and ETFs) to a whopping 38.24% (for Ameritor Security Trust). Investors need to get a handle on the range of total expenses for particular classifications of interest. For example, for the period ended September 30, 2010, the median total expense ratio for retail money market funds was 0.344%, while sector equity funds’ median expense ratio was 1.510%—quite a difference. Obviously, money market funds don’t take as much research effort as do science and technology funds or health biotechnology funds.
For fund share classes back-end load (sometimes called B shares) and level-load (aka C shares) have significantly higher total expense ratios than do no-load, institutional load, or front-end load. The main difference between these groups from an annual expense point of view is the 12b-1 fee, which is paid out of fund assets to cover the cost of marketing and selling fund shares and sometimes for shareholder servicing. The back-end/level-load group generally charges 100 basis points (bps) in 12b-1 fees, whereas the latter group charges 0-35 bps. We can see that a 65-bp difference over a ten-year period can produce very different returns. Low-cost fund providers also provide cost-structure reductions. So, when you are looking into expenses, remember that you can prop up your returns by identifying the strongly performing funds with lower costs within a classification.
Lipper provides a Lipper Leaders expense rating for funds on three-, five-, and/or ten-year bases. To create a meaningful comparison we group comparable load structures; that is, we pit no-load and front-end load funds against one another, level-load against back-end load funds, and institutional-load funds against themselves. As with our other nonperformance-related ratings, we highly recommend that investors use a performance measure (total return or risk-adjusted return) in concert with ratings for total expense; sometimes when you buy the cheapest that is what you get. On our Fund & ETF Screener page (url: http://tinyurl.com/yehynxh) you can screen on both expense and performance criteria, with the goal of identifying inexpensive top-performing funds.
Figure 2 Average Ten-Year Performance Sector Equity Funds by Load Type
Taxes
For taxable mutual fund investors, paying close attention to after-tax returns can pay strong dividends as well. In the example above taxes accounted for 124 bps of drag each year for the average front-end load sector equity fund over the preceding ten years. In the late ’90s and early ’00s the average tax drag for equity funds was two to three times larger than the average expense drag. During that period the average equity fund gave some 200-300 bps of its load-adjusted return each year to Uncle Sam. Investors were losing 2-3 percentage points of their load-adjusted return for doing nothing more than buying and holding their funds!
Keep in mind that in order for a fund to retain its regulated investment company status with the IRS (and avoid triple taxation), it must pass through to investors virtually all of its capital gains and income distributions each year. So, even if we don’t sell any portion of our fund, we are still subject to a taxable event because of the trading activity of the portfolio manager. Unfortunately, during losing years a fund is not allowed to pass through its losses. But, if losses are incurred, they can be used to offset gains during the current tax year or be carried forward to the next year. With two significant losing events in the last decade (the 2000-2002 market decline and the 2008 meltdown), equity funds amassed a great deal of tax-loss carryforwards, bringing about a tax holiday of sorts for investors. But, those carryforwards may have been completely used up by the strong returns we witnessed in 2009 and 2010.
Taxes are one of the performance drags over which we have a significant amount of control. We can choose to put very tax-inefficient funds into our qualified account (401[k] or IRA), purchase tax-efficient funds for our taxable account, or even buy fairly tax-inefficient funds that have amassed large tax-loss carryforwards. In addition, we can purchase fund types that appear to be more tax efficient than most: index funds, equity exchange-traded funds, tax-managed funds, and of course municipal debt funds. Interested investors can compare their funds’ Lipper Leader ratings for tax efficiency against other funds within the same classifications. We need a caveat here: measures of tax efficiency should not be used in isolation but need to be used in concert with measures of performance. For example, the old Steadman Fund was the epitome of tax efficiency. The fund paid out no capital gains or income distributions and in fact lost money in most of its years in operation. Despite its grand tax efficiency, it definitely was not a fund to buy. So, also use a measure of performance when identifying tax-efficient or even low-cost funds. Remember, the pennies you save today could turn into your windfall tomorrow. The power of compounding is magical.
This article first appeared in On Wall Street Magazine on June 1, 2011.
