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Knowing the costs of your investments and how those costs relate to your ultimate return is an important part of investor education for physicians.
As for-profit businesses, mutual fund companies charge their investors for their services. The expense ratio is only one of the costs an investor pays for the management of assets. Knowing the costs of your investments and how those costs relate to your ultimate return is an important part of investor education for physicians, and can be very useful when selecting investments for your personal or retirement plan portfolios.
In a recent article in the Wall Street Journal, Burton Malkiel, the author of "A Random Walk down Wall Street," described an increase in asset management fees of non-index mutual funds relative to the growth of their assets from 1986 to 2006. His conclusion: "…investors have received no benefit from this increase in expense ratios." His comments refer specifically to the mutual funds’ expense ratio, or the cost of operating the funds as a percentage of the assets managed. According to Malkiel, the average expense ratio of actively managed funds in 2010 was 0.91 percent. In contrast, index fund expense ratios may be as low as 0.05 percent, depending on the index. In that these dollars come directly from the assets and are not paid separately by the investor, it is not surprising that many investors are not aware of the ongoing cost of their investments. Operating costs include securities research and the personnel costs of those who do it. It also includes the costs of trading as well as some of the costs of promoting the fund to the public. Additionally, funds must disclose whether they pay 12b-1 fees, which in part are paid to entities that recommend the funds to investors. These can be thought of as sales commissions. All of this information must be disclosed as mandated by the SEC.
So mutual fund companies that pay high prices for securities analysts to pick stocks and determine the best time to buy and sell - termed active management - should be able to do a better job than those funds that don’t do extensive research or whose trading philosophy is to replicate the performance of an index or an asset class, right? Well the data actually says the opposite. In a study released in 2010, Morningstar, a well-known mutual fund evaluation service, reported that the expense ratio of mutual funds was a better predictor of performance than even its own rating system. Morningstar’s findings stated: "In every asset class over every time period, the cheapest quintile [of mutual funds] produced higher total returns than the most expensive quintile." Their conclusion was simple: "Investors should make expense ratios a primary test in fund selection."
Typically, the lowest cost funds are those that track an index or an entire asset class. These funds spend relatively little on research and have low portfolio turnover, hence lower trading costs. These savings are passed along to the investors. Index funds do have the disadvantage, however, of having to "reconstitute" at set times during the year. Because this is public information, knowing that reconstitution is about to occur can unfavorably affect the prices of the securities the funds must buy and sell. By contrast, asset class-based mutual funds might be able to avoid this issue while still providing a low-cost alternative to traditional active management.
But how does the performance of these lower cost funds compare to those actively managed? According to Malkiel, over long periods of time, only one-third of active managers are successful in outperforming a benchmark index. And generally, this one-third changes from period to period.
It is not clear from this and similar research that the cost of active portfolio management - picking stocks and timing the market - can be justified. Investors cannot control what will happen in the markets. The defense is to remain globally diversified. But investors can control the costs of their investments, and according to noted sources, will be rewarded for doing so.
So how is this information useful? It is common for corporate 401(k) plans to offer a list of mutual funds from which to choose. This list often includes a brief description of the goals of the fund as well as its cost. When given the choice between funds that have similar investment philosophies, consider the one with the lowest expense ratio. Favor low-cost index or asset class funds over higher cost actively managed funds. Choose a combination of funds that provides the broadest possible diversification. And get the help of an investment advisor whose compensation is not dependent on the funds he or she recommends.