Mutual Fund Secrets

Hidden mutual fund costs can diminish your returns.
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If your employer sponsors a retirement plan, mutual funds are hard to avoid. They're the backbone of nearly every 401(k) program. But before you strike out on your own and plunk additional investment money into mutual funds, learn the stuff mutual fund companies don't advertise. That will help you take advantage of mutual funds' benefits – a diversified portfolio, professional management, low-cost entry and low-dollar incremental additions – and minimize the downsides.

Manager Involvement

An increasing number of mutual funds track a specific index – the S&P 500, for example – but a majority of mutual funds' investments are picked by a manager or a management team. The fund company will provide the manager's record with the fund. However, you need to do more digging. Check how much money the manager has invested in the fund. You want a manager who believes in his picks. Also, go through the company's other funds. If your manager also handles two or more other funds, she may be spread too thin. Even the best investor has a finite number of good ideas.

Fund Fees

Mutual fund companies publish the expense ratio for each fund. Those fees – for paying the portfolio manager and operating expenses – get reported as a percentage of assets and bite into your return. The longer you own the fund, the more those fees cut into your return. It's because of compound growth. Mutual funds provide annualized returns for one year, five years, 10 years, sometimes even 15 or 20 years, but the fees reported cover only one year. If the company reports an annual return of 6.1 percent with an expense ratio of 1.2 percent, your effective return for one year comes in at 4.9 percent. But over five years, $1,000 getting a 6.1 percent return grows to $1,345; at 4.9 percent it's $1,270, a difference of 5.6 percent. Over 10 years, the difference increases to 10.7 percent, but let's take it out 50 years. At that point, your $1,000 at 4.9 percent leaves $10,934 in your pocket instead of $19,309 from a 6.1 percent return. Where did the missing $8,375 go? To the mutual fund company, of course.

Investment Costs

Comparing fund fees is the easy part. Funds incur other costs, not reported in the expense ratio, from buying and selling assets in the portfolio. Those unreported charges can make a fund considerably more costly than advertised. A 2009 study cited in the Wall Street Journal pegged average mutual fund trading costs at 1.44 percent annually, but another estimate included in the WSJ article put yearly investment costs between 2 and 3 percent. Morningstar, an independent fund analyst company, provides the turnover percentage for each fund. The higher the turnover percentage, the more trading expenses your fund is chalking up.

Fund Drift

Fund names often provide information on the investments within the portfolio – "Small-Cap Value," "Science and Technology" or "Dividend Growth." If you're looking to build a diversified portfolio with a certain percentage in small-company stocks, bonds, large company stocks and foreign stocks, for instance, the names can be foolers. The fund might have started with small-company stocks, but those firms might have outgrown your definition of "small." Or the fund manager might have chosen to hike his dividend payouts by buying a bunch of preferred stocks, which have limited growth potential. The name didn't change, but the style did, with no notification. Check out the fund's current investment style at Morningstar.

Mutual-Fund Monte

Investments you see in the prospectus aren't necessarily what you get in the fund. The prospectus list provides a snapshot of what the fund held on the day the picture was taken. But funds with a high turnover ratio easily could include fewer than half the stocks listed in the prospectus when you make your initial purchase, and that percentage likely will drop daily.

Index Funds

Even funds that claim to exactly mimic a specific market index won't match the index return. Fees and trading costs are guaranteed to bring you in below the market.

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