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 (NYSE:SCHB) or emerging markets fund (NYSEA: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%|
|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 (NYSEA:DVY) and long-term bonds (NYSE: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.