As the Ben Franklin quote goes: "A penny saved is a penny earned." And with today's topsy-turvy market and with fees and expenses playing an important role in the accumulation of wealth for the long-term, the saying is still apt.

While risk and return are primary tools for evaluating mutual fund investments or potential additions to our portfolio — loads, expenses and taxes (three major drags on fund performance) — must also be considered. These factors can have a significant impact on returns over the long haul.

In a Lipper report entitled Taxes in the Mutual Fund Industry, the average front-end load sector equity fund lost 21.6% of its average annualized 10-year gross return to expenses. It lost another 7.7% to loads and 16.7% to pre-liquidation taxes. That means the average sector equity fund retained only 54% of its gross return after accounting for load, expenses, and taxes. So how can we limit these drags on performance?

Fees and Expenses

A mutual fund's total expense ratio is comprised of management fees, 12b-1 fees (distribution and/or service fees), and other expenses (custodial, legal and accounting, transfer agent, and other administrative expenses). Total expense ratios can range from a few basis points (for passively managed index funds and exchange-traded funds), to a whopping 38.24% (for Ameritor Security Trust).

Investors need to get a handle on the range of total expenses for particular classifications of interest. For example, in the period ended Sept. 30, 2010, the median total expense ratio for retail money market funds was 0.344%, while sector equity funds' median expense ratio was 1.510%. Obviously, money market funds don't take as much research effort, as do science and technology funds or health biotechnology funds.

Back-end load (B shares) and level-load (C shares) have significantly higher total expense ratios than do no-load, institutional load, or front-end load. The main difference between these groups, from an annual expense point of view, is the 12b-1 fee, which is paid out of fund assets to cover the cost of marketing and selling fund shares, and at times shareholder servicing. The back-end/level-load group generally charges 100 basis points (bps) in 12b-1 fees; the latter group charges 0-35 bps. We can see that a 65-bp difference over a 10-year period can produce very different returns.


For taxable mutual fund investors, keeping an eye on after-tax returns can pay strong dividends as well. In the late 1990s and early 2000s the average tax drag for equity funds was two to three times larger than the average expense drag. During that period, the average equity fund gave some 200-300 bps of its load-adjusted return each year to the government. Investors were losing 2% to 3% points of their load-adjusted return for doing nothing more than buying and holding their funds.

Taxes are one of the performance drags over which we have a significant amount of control. We can choose to put very tax- inefficient funds into our qualified account, such as a 401(k) or IRA; buy tax-efficient funds for our taxable account; or even buy fairly tax-inefficient funds that have amassed large tax-loss carryforwards. In addition, we can buy fund types that appear to be more tax efficient than most: index funds, equity ETFs, tax-managed funds, and of course municipal debt funds. Interested investors can compare their funds' Lipper Leader ratings for tax efficiency against other funds within the same classifications. We need a caveat here: measures of tax efficiency should not be used in isolation but need to be used in concert with measures of performance. Use a measure of performance when identifying tax-efficient or even low-cost funds.

Remember, the pennies you save today could turn into your windfall tomorrow. The power of compounding is magical.


Tom Roseen, is a senior analyst with Lipper.
He is the editor and an author of Lipper's U.S. Research Studies,
Fundflows Insight Reports and FundIndustry Insight Reports.



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