There's a portion at the end of every mutual fund's annual report that, if you read it closely, just might change your view on “fees,” or, more appropriately, mutual fund operating costs (commonly called the “expense ratio”). But before I get to that, let's review the game everyone plays when it comes to fees.
Fees are bad. Retirement savers pay too much in fees. Why, did you know that several white papers even say ordinary workers will lose anywhere from $150,000 to more than a quarter-million dollars? That's maybe a third or more of their earnings. All lost to those terrible fees.
Only, the bulk of these “fees” consist of mutual fund operating costs. One widely quoted study even includes “trading” expenses (i.e., brokerage commissions incurred when buying and selling underlying securities within the mutual fund's portfolio). Here's the too-often-ignored mathematical reality: Mutual fund returns already incorporate both brokerage commissions and expense ratios.
This is where that “expense table” in the fund's annual report comes in. The SEC requires every mutual fund to report both the actual dollar-denominated costs as well as a “hypothetical” calculation which assumes the fund has a 5 percent annual return. What this means is the SEC wants shareholders to compare the expense ratio of all funds based on this hypothetical 5 percent return. The trouble is, that's not what the annual report shows. It only shows the actual versus hypothetical expenses paid based on the expense ratio of the mutual fund.
Think about this. If the actual return exceeds 5 percent, the “actual” expenses paid will be more than the “hypothetical” fees paid. For example, if your fund grew by 10 percent, the actual fees paid will be shown in the table to be twice that of the hypothetical fund.
Do you think the typical shareholder might assume these higher “actual” fees indicate the fund is bad? This is where a close examination might cause you to stop worrying about fees and even learn to love them. Why? Because in order to suffer those higher fees, you would have had to be blessed with an equally higher return.
This is the problem with including the expense ratio (and trading commissions, for that matter) in any discussion of fees. Since fund returns already incorporate these expenses, to include these costs as “fees” amounts to double-counting them. It's not just widely quoted white papers that make this mistake. Even the SEC has inadvertently committed this same error.
Here's what I mean: In the case of the expense table calculation, let's say you have $100,000 and you earn 10 percent on a fund with an expense ratio of 2 percent. You'll have earned $10,000, including $2,033 in actual expenses paid. The hypothetical fund (which rose only 5 percent) would have earned $5,000, including $2,008 in hypothetical expenses paid. So, let me ask you this question: Would you rather pay $25 more in order to earn $5,000 more, or would you rather save that $25 and earn $5,000 less?
Higher “fees.” Gotta love them.
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Christopher Carosa
Chris Carosa has been writing a weekly article and monthly column for BenefitsPRO online and BenefitsPRO Magazine since 2011 and is a nationally recognized award-winning writer, researcher and speaker. He’s written seven books, including From Cradle to Retire: The Child IRA; Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort; A Pizza The Action: Everything I Ever Learned About Business I Learned By Working in a Pizza Stand at the Erie County Fair; and the widely acclaimed 401(k) Fiduciary Solutions. Carosa is also Chief Contributing Editor of the authoritative trade journal FiduciaryNews.com and publisher of the Mendon-Honeoye Falls-Lima Sentinel, a weekly community newspaper he founded in 1989. Currently serving as President of the National Society of Newspaper Columnists and with more than 1,000 articles published in various publications, he appears regularly in the national media. A “parallel” entrepreneur, he actively runs a handful of businesses, including a small boutique investment adviser, providing hands-on experience for his writing. A trained astrophysicist, he also holds an MBA and has been designated a Certified Trust and Financial Advisor. Share your thoughts and story ideas with him through Facebook (https://www.facebook.com/christophercarosa/)and Twitter (https://twitter.com/ChrisCarosa).
