Financial Reference

I had my first confusing experience with mutual funds in high school. I have always been frugal (though everyone else calls me cheap) and so by my senior year in high school, I already had a decent savings. My parent’s financial advisor led me through the process of selecting the funds. She gave me a list of single page Morningstar reports and recommend I select 2-3 funds with 4-5 stars.

I had no clue what I was doing. Is there any other relevant data? Why did some funds have much larger returns than others, even though they were all 4-5 stars. I guess I could choose the right fund like my wife chooses bottles of wine — based on the name and packaging. But I didn’t even have a pretty package to judge; I only had a name, major holdings, return information, expense information, portfolio turnover, and number of stars.

I soon realized that one of the most common investments is also one of the most confusing. I worked hard and passed on a lot of fun purchases to have the money to invest. But, at that point in my life, I had no choice but to make an uneducated decision and risk everything. Everything turned out okay but over time I learned enough to make better investment decisions every year. Hopefully, you will be able to make better decisions in the future as well.

It many seem, at first glance, that the most important consideration is past return. If management performed well in the past they should perform well in the future. Right? Wrong. Good past performance is not indicative of good future performance.

But low expenses are very predictable. And low expenses are predictive of performance. However, this is often one of the most confusing areas of analysis. There are three important numbers to know related to expenses: the total expense ratio, the load, and the turnover. The total expense ratio is the most important piece. It is composed of management fees, distribution fees, and other expenses. This is expressed as a percentage of assets and can run anywhere from 0.1% to over 2%. The difference seems small but through compounding can cost the investor a lot of money. For example, a fund I previously owned (when I didn’t know better) is Davis New York Venture C (NYVCX). The fund has an expense ratio of 1.68% of which 1% goes toward selling the fund (12b-1 fees). Why should I get lower returns so they can get more assets under management.

The load is the cost of buying or selling the fund. A front-end load is the cost of buying the fund while a back-end load is the cost of selling the fund. It’s yet another way to give your money to the fund company.

The most hidden fees are in the turnover ratio. They cost you in both transaction fees and in taxes. And there is no reason to incur such huge turnover. If a manager has new ideas every few months, his ideas can’t be too good. And this is born out by the data: as turnover increases, performance decreases. (See SmartMoney Feb. 06, p. 42).

So, instead of looking at past performance, look at expenses. That is find a fund with low annual expenses, no load, and low turnover. And maybe next time you won’t struggle through selecting a mutual fund. Just look at the relevant data (expenses) and don’t chase the noise (past returns).