Don't Let Funds Steal Your Income
Ron DeLegge, Editor
July 26, 2012
On January 1, 2011 the oldest members of the Baby Boom
generation turned 65 years old and millions of them are investing
in mutual funds that are stealing income from their bottom line.
Since so many Boomers have changed from growth to income investors,
they are relying on the income from their investments to sustain
their lifestyle. How much income are your mutual funds
devouring?
Fund Expenses 101
It may come as a surprise to some, but there is no such thing as a
"free" mutual fund or "free" investment. In my former life as a
financial advisor, I had a prospective client tell me his mutual
fund portfolio wasn't costing him anything. I showed him that he
was indeed paying fees, but he still didn't believe me. (About 5
minutes later, I was invited to leave.)
Broadly speaking, mutual funds fall into one of two categories;
"no load" or "load."
No load funds, as the name implies do not incur a sales charge,
but if you purchase the fund through a fund marketplace, brokerage
firms will typically charge you a transaction fee to buy or sell
the fund.
In contrast, load funds charge upfront or backend commissions,
which are paid to a fund salesperson.
Once you've purchased a mutual fund, the ongoing fees you pay
are called the "expense ratio." This ratio or cost is the
percentage of a portfolio's average net assets used to pay its
expenses. Among the costs included in a fund's expense ratio are
management fees, administrative fees, and 12b-1 marketing fees.
Even though these fees aren't necessarily billed via a monthly
invoice, they are a significant ongoing cost that directly reduces
investor returns and income.
Look Beyond the Surface
The conventional step for comparing mutual fund expenses is to use
peer group comparisons by analyzing funds in the same category. For
instance, the fund expenses of a large cap (NYSEArca: SCHB) or
emerging markets fund (NYSEArca: EEM) is compared to its peers in
that same category. And if the annual fees or expense ratio for a
particular fund is more than its peers, then it's overcharging and
if it's less than it's not. While peer group comparison are OK for
analyzing mutual fund expenses, they only tell part of the
story.
ETFguide uses an alternative benchmark for mutual fund costs
that gets straight to the bottom line: The percentage of income
that fund expenses are taking from investors based upon the fund's
12-month yield. By this standard, many mutual funds don't pass the
smell test.
In FIGURE 1, we evaluated the expense ratios and yields of
popular income mutual funds to find out how much income was being
consumed by the fund's annual expenses. We looked at the Fidelity
New Markets Income (Nasdaq: FNMIX), Fidelity High Income (Nasdaq:
SPHIX), Franklin Utilities (Nasdaq: FRAUX), Loomis Sayles (Nasdaq:
LSBRX), and T.Rowe Price Equity Income (Nasdaq: PRFDX).
FIGURE 1: Percentage of Income Consumed by Popular Income
Mutual Funds
|
Fund Name
|
Ticker
|
Expense Ratio (ER)
|
Yield as of 4/30/12
|
% Income Consumed by ER
|
|
Fidelity New Markets Income
|
FNMIX
|
0.86%
|
5.37%
|
16.0%
|
|
Fidelity High Income
|
SPHIX
|
0.75%
|
6.67%
|
11.5%
|
|
Franklin Utilities
|
FRUAX
|
0.61%
|
3.49%
|
17.5%
|
|
Loomis Sayles Bond
|
LSBRX
|
0.92%
|
5.58%
|
16.5%
|
|
T.Rowe Price Equity Income
|
PRFDX
|
0.68%
|
1.94%
|
35.0%
|
We discovered that fund expenses among popular income mutual
funds were sucking away between 11% to 35% of investor's income.
It's an unnecessary tax! But unlike taxes, this particular tax - a
mutual fund tax - can be avoided. How?
Want More Income? Here's the Secret
If you own mutual funds that are devouring your income, using lower
cost
ETFs
in their place is a winning strategy. Step 1 is to start looking at
your fund investments in terms of how much of your income they are
eating up and Step 2 is to eliminate them.
Step 3 is to realize that traditional income methods like
investing in dividend paying stocks (NYSEArca: DVY) and long-term
bonds (NYSEArca: TLT) are limited in the current environment.
Income investors have been damaged because of artificially low
interest rates and these particular categories are not generating
the kind of income they once did.
Our $100,000 all
ETF Income Mix
Portfolio
has generated just over $7,000 in monthly income
year-to-date. The expense ratio average for this portfolio is
0.18%, which is five times less compared to the funds listed in the
table above. You're keeping most of the income generated by your
investments, which is the way it should be.
In summary, don't let fund companies steal your income
with high fees.