How Do Fees Affect Mutual Fund Performance?

A mutual fund’s fees and expenses may be more important than an investor might realize. Ads, rankings and ratings will often emphasize how well a fund has performed in the past. But according to the Securities and Exchange Commission (SEC), studies show that the future often is different. Fees and expenses can be a reliable predictor of mutual fund performance.
When considering a mutual fund, one of the most important numbers is the expense ratio, which tells you how much the fund costs. The ratio shows how much of the fund’s assets are paid to the portfolio manager and for other operating expenses. Typically, a fund pays an average of 1.5 percent of assets annually.
Three things typically figure into this ratio. The investment advisory fee pays the managers of the fund, which accounts for .50 to 1 percent. Then, administrative costs cover services such as record keeping, mailing and maintaining a customer service line, which can range from .20 to .40 percent. And often a fund will charge a 12b-1 distribution fee, which covers marketing, advertising and distribution services. This ranges from .25 percent to 1 percent of assets.
The upper range of these fees shows how high an expense ratio can be. And even though the fee seems to be just a few percentage points, it is charged in down years, when it can represent a significant slice of the return. Also, over time, the fee can cut the ultimate return by nearly 50 percent, according to one analysis. With an initial $10,000 invested after 30 years of 10 percent returns (a bit optimistic, perhaps), the fund has made $174,494, but with a 2.5 percent expense ratio, it has lost $86,944, according to an analysis by Moolanomy.com.
But even that isn’t the bottom line. There are still transaction fees incurred by the buying and selling of assets in the fund that go unreported, and that can double or triple the cost, according to Richard Kopcke of the Center for Retirement Research at Boston College.
Of the 100 largest stock funds held in defined contribution plans as of December 2007, trading costs averaged from 0.11 percent of assets annually in the quintile with the lowest costs to 1.99 percent of assets in the quintile with the highest costs, with a median of 0.66 percent, Kopcke found. But it is difficult for average investors to determine this percentage, he said.
The SEC has not been able to develop ways to report this percentage in the same way an expense ratio is reported, partly because fund managers say the number is too difficult to determine. One way to get an indication of the percentage is the fund’s turnover. The percentage of turnover shows at what rate stocks in the fund have been replaced. A high turnover rate would mean more fees.
The SEC last year required fund managers to disclose one year of turnover at the front of a prospectus in addition to the already required five years of turnover disclosed in the financial highlights section, according to a March 1 Wall Street Journal article. Turnover of more than 100 percent can indicate trading costs may be high, the Journal reported.

Posted on August 1, 2010 Read More

How Do Derivatives Affect the Economy?

Derivatives protect people from a change in prices of an underlying asset. They began, generally speaking, as a hedge against changes in commodities prices. So, if you are a corn farmer and want to be able to plan on how much you will receive for your crop, you can agree on the price with a miller. The farmer is in a sense betting that the price will be higher or at least the same as the rest of the market at harvest time, and the miller is betting that the price will be lower or at least the same – and the miller is ensured of a supply of corn. The result is stability for both parties. The agreement is derived from the underlying asset of corn. That is the essence of a derivative.

Derivatives also hedge against price changes in other financial instruments and can become far more complicated or “exotic.” An institution can buy a credit default swap (CDS), for example. Institution No. 1 would pay institution No. 2 to ensure that the value of an asset does not fall under a certain level. If the value does drop, then No. 2 would pay No. 1. When the value of real estate plummeted in 2007 and 2008, many No. 1 institutions were banging on No. 2 institutions’ doors to get paid. This was one of the factors leading to the economic collapse, when the overall value of the CDS market dropped from $62.2 trillion at the end of 2007 to $38.6 trillion at the end of 2008, according to the International Swaps and Derivatives Association.

Another factor was collateralized debt obligations (CDOs). These are packages of debts such as bonds or mortgage-backed securities. The idea is to reduce risk by spreading it around. But some in finance, such as Warren Buffett, said that they instead spread risky investments to more institutions. So when the underlying, or derived, asset plummeted, the rug was pulled out from under everyone.

Although some, like Buffett, had sounded the alarm on derivatives, many people were surprised by the enormous impact the instruments had on the financial sector in the collapse of September 2008. Regulators were also surprised, because derivatives are often unregulated because they are essentially an agreement exchanged between parties but amount to a $400 trillion market traded over the counter (OTC).

Financial reformers want to shed more light on the market, but on April 21, a Senate committee went even further than that and approved tough standards that would force banks to get rid of their swaps trading operations. That rule might not make it to the final financial reform package, but it is certain that the eventual law will clamp down on derivatives in some way.

Posted on July 1, 2010 Read More

What is a Company’s “Cap”

The term means market capitalization – the market value of all of a company’s existing shares. It is basically a company’s shares multiplied by the current market price of one share. Investors gauge a company’s price by this rather than by sales or assets. It is also an effective way to see how the economic downturn of 2008 affected the financial world. The total market capitalization was as high as $57.5 trillion in May 2008, slid to $50 trillion in August and then went down to $40 trillion in September 2008, according to the World Federation of Exchanges.
There are no hard rules about the values of each designation. One gauge says small-caps are less than $2 billion in value, mid-caps are up to $10 billion and large-caps are more than $10 billion. Others say mid-caps start at $5 billion and small-caps start at $1 billion. And still others have added more categories: mega-caps, more than $200 billion; micro-caps, $50 million to $300 million; and nano-caps, below $50 million.
The size makes a difference in investor expectation. Small-cap stock values can grow or shrink quickly. The gain may be great, but so is the risk. These companies can grow into mid- and large-cap companies, taking investors along for the ride. But they also have less to fall back on when times are tough. They can drop in a hurry, again taking their investors with them.
Large-cap companies, which make up half of total market capitalization, tend to be steady in their performance. They are usually the companies that dominate their industry and are not likely to grow any more enormous by percentage, or to shrink, for that matter. These entities are often devoted to maintaining their position. So the investments are usually steady.
Mid-caps are considered a mix of small-cap and large-cap. They often have ambitions to grow into a large-cap, but that drive can also lead them to take risks. The companies are still substantial and are not likely to take ill-advised risks.
Investors should assess their risk tolerance before deciding to invest in stocks. Then they can determine which class of companies to put their money into. Many mutual funds specialize in different groups, so investors can take advantage of company size characteristics but spread the risk at the same time. The funds that track indexes such as the S&P 500 focus on large- or mega-cap companies, which offer stability and slower growth. They usually stumble only in significant downturns such as those after the 9/11 attack and the financial meltdown of 2008.

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Posted on June 1, 2010 Read More

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