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The Value of Your Mutual Fund
In the coming months, there will be added pressure on mutual fund investors both long term and short term. No there isn't another scandal brewing but if there was, the cleansing would be still welcome. In my opinion, each time some law enforcement official from Spitzer to the S.E.C. closes in on the trail of some scoundrel committing legal larceny, I cheer. I only wish that they would use the same protocol awarded all victims, notifying them before the public. While these pursuits are justified and of great concern, what will have the greatest impact on investors in the coming quarters will be valuations.
Valuations are used by the industry to compare their stock picking prowess to similarly invested funds, usually an index fund closely related to their style. If an index such as the S&P 500 is used, it is widely believed that the fund invests primarily, if not solely in large capitalization companies. Capitalization is a word used to explain the worth of a company based on stock outstanding and price of that stock.
But the wary investor should be on the lookout for unfair comparisons. This is nothing new in volatile environments, your fund manager will tell you as they try to explain why their work was sub par. An environment like this, if you think about it, should be to their advantage. How often have you heard the expression "stock picker's market" used when describing the last several weeks? Your fund manager is considered a stock picker, who, albeit governed by charters that restrict some investment moves, should be able to eek out a return even in uncertain market conditions. As many of you have heard on your television, "there are opportunities out there".
So why will your fund managers be backpedaling come the end of the next quarter? To do so would be to admit that the fees they charge are out of line with the job they have done. When an investors does sector wide comparisons, it usually the fees that create the difference between beating the comparative index and not. The argument goes something like this: If an investor buys as large cap growth mutual fund and holds that fund for ten years and in that same year, purchased an index fund, holding on to it for the same decade, the index fund will have outperformed the growth fund by 1.7% according to Standard & Poors. Doesn't sound like much to some of you, but that is a lot of potential gains lost year over year because of fees.
Each year, an actively managed fund is handicapped by the fees they charge. If your fund is charging 1.3% in management fees, the manager must better the index, usually a fund with a bare minimum of fees averaging close to .25%. That puts him down 1.05% to start. Add in a rocky market governed by growing uncertainty and you will have lost before you have begun.
But it doesn't end there. While these fees will prove too heavy a burden to pay if the markets begin to turn into single digit earners, bubbling to the surface during such an event will be all of the other fees not listed under total expenses. That ratio does not include the cost of buying and selling stocks within the fund. The more actively managed the fund, the higher these commission costs, which are taken from the performance side of the equation. The net effect of trading actively, according to Lipper, inc. can cost as much as .40% of the total return.
The domino effect of higher fees continues to weigh against investors chances as old investors cash out as often happens when funds turn in less than expected returns without new investors replacing them. This creates increased turnover and cash sensitive positions.
While questions have arisen regarding the strength of index funds in a bull market, no one sector's averages have been able to beat the indexes over the long term. The tired old mantra of low fees and expenses will pay dividends for investors who have let the stock pickers struggle as they patiently invested through the high and the low.
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