Cost Control

THE CORROSIVE EFFECT of fees and taxes is the single biggest disadvantage of investing in mutual funds.

Our view is that the entire fund industry suffers from a serious cost-control problem that contributes to the subpar returns posted by too many funds. If you aren't careful, management expenses and capital gains taxes can shave hundreds -- if not thousands -- of dollars from your returns over the years. Play around with our interactive Fund Fee Analyzer and see for yourself how much a high load or expense ratio can eat into returns.

Then read on to learn more about how to evaluate a fund's fees and tax efficiency. The good news is that it's still possible to find excellent funds with relatively low costs. You just have to know what to look for.
 

One point we would make from the top, however, is that index funds are by nature the lowest-cost funds because of their lack of active management. As you'll see, they're also the most tax efficient. If your goal is to get into the market as cheaply and simply as possible, index funds are probably the way to go.

Loads
Mutual fund people talk a lot about load funds and no-load funds. A "load" is simply a sales charge tacked onto the price of a mutual fund to compensate the broker or financial adviser who sells it to you. Loads work two ways. You pay them either upon buying your shares or selling them, depending on the fund.

A "front-end load" is charged when you buy your shares. It typically ranges between 2% and 6% of your initial investment, and some funds charge you again for reinvesting your dividends in new shares of the fund. A "back-end load" is a fee the fund charges when you sell -- or redeem -- your shares. These deferred fees are essentially a tactic to keep you invested in the fund for the long term. A typical scenario would work this way: In the first year of ownership, you'd pay a charge in the range of 4% to 5.75% if you sold out of the fund. After that, the percentage declines each year until it disappears altogether after about six years.

The obvious problem with a load is that it immediately trims your investment return. That might be acceptable if you believe the fund will post such superior returns that the load will pay for itself over time. But since there are plenty of quality no-load funds out there, why pay a fee when you don't have to? We never say never when it comes to paying fees, but at SmartMoney, we tend to recommend no-load funds exclusively.
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Expense Ratios
Even a no-load fund hits up its shareholders for the costs of doing business. These include everything from the advisory fee paid to the fund manager to administrative costs like printing and postage.

These costs are expressed as an "expense ratio," which is an annual percentage of the fund's average net assets under management. Published fund returns are usually calculated net of annual expenses, but you should definitely pay attention to them. When you get your statement at the end of the year, you can count on the costs being skimmed off the top.

There's a temptation to associate high expenses with good fund management. Some people figure it's like anything else: You get what you pay for. The fact is, however, that low-expense funds are more likely to outperform high-expense funds over the long haul. Recently, the average expense ratio for domestic equity funds was about 1.4%. For fixed-income funds, it was about 1.1%. International funds have higher expense ratios, averaging around 1.9%. There is no reason to buy funds with expense ratios higher than that.
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12b-1 Fees
These are fees the fund charges for marketing and distribution expenses. They are included in the expense ratio, but often are talked about separately. These fees are charged in addition to a front- or back-end load, and you'll find that many no-load funds charge them, too. If a 12b-1 fee puts a fund's expense ratio above the average for that class of fund, think twice before buying.
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Taxes
Our Taxes and Investing section covers this issue in much more depth, but when it comes to mutual funds and taxes, the basic issue is this: When a fund manager sells a stock for a gain, the law says it becomes a taxable event. That transaction may be offset by any losses the manager incurs when he sells a doggy stock. But if the sum of all the transactions during the year equals an overall gain, somebody has to pay the tax bill. We'll give you three guesses who that ends up being.

These gains are paid out in the form of taxable distributions. There's nothing worse than ending the year with a fat one you weren't expecting. It's even more bitter when the gain falls into the short-term category -- a big problem with fund managers who trade often. Short-term gains are taxed as regular income instead of at the lower 20% tax rate levied on long-term capital gains.

In 1998, some funds had distributions as high as 28% of their total assets. Shareholders paid taxes of anywhere from 20% to 39.6% of that. The only way to avoid the problem is to look for fund managers who don't typically trade a lot. In 1997, for instance, Phoenix Aggressive Growth had a turnover ratio of 518%, meaning that during the year, the fund manager sold 518% of the stocks in his portfolio. Shareholders got slapped with a 20% distribution, most of it short-term gains. By contrast, Torray Fund had a 12% turnover and its distribution was only 1.7% of net asset value.

When it comes to tax efficiency, you can't beat index funds. By charter they don't trade much; they buy the stocks in an index and hold onto them for the long haul, rebalancing them only when they have to. If you want an actively managed fund, however, make sure you pay attention to the churn rate.
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