Throughout many years of investing in no-load mutual funds within my own retirement accounts, I’ve noted that professional financial advisors typically affirm three factors to be most important for analyzing a candidate group of funds and then deciding which one to purchase. They are:
Type of fund:
Value, growth, small cap, mid cap, and so forth.
Performance return and management trend of fund:
Comparing funds within the same Type, or against a benchmark like the S&P 500; also reviewing the track record of the fund manager.
Cost of fund:
Reviewing the “expense ratio.” Values typically range between one half and two percent of assets held within the investment account.
While all three factors are relevant to making a prudent investment decision, I respectfully disagree with the pundits. More specifically, I believe the third factor (cost of fund/ expense ratio) matters far less and deserves a much reduced, but not altogether eliminated, role in selecting no-load mutual funds and accomplishing my investment goals. Here’s why:
First, it’s essential to understand that mutual fund performance listed in prospectuses and financial publications is almost always reported as a net value after deducting applicable costs, which include the expense ratio. This means that the higher the expense ratio, the more the fund will need to yield in order to overcome this “cost drag” and out-perform funds with lower expense ratios.
For example, say that $10K is invested into each of two competing mutual funds with expense ratios of 1% ($100) and 2% ($200), respectively, and that after one year both report a return of ten percent. Since fund performance is reported after expenses, in BOTH cases the investment value would be the same – $1100. This shows how an investor holding a fund with comparatively higher cost is NOT necessarily penalized with a lower return. It also highlights some subtle but critical perspective for ensure a realistic interpretation of mutual fund performance data.
As illustrated above, the expense ratio by itself is not all that meaningful in evaluating no-load mutual funds; performance return is far more important. I consider the expense ratio’s relevance in a much narrower, more subjective context. Mainly, I simply need to judge whether the mutual fund manager can continue achieving performance returns sufficient to overcome the expense ratio and outperform peer funds and relevant benchmarks (i.e. S&P 500).
Successful investing can be challenging, and the strategies, principles and professional opinions on the subject are boundless.
But, I’ve reached a hard-fought conclusion that cost, most specifically the expense ratio, is not all that important when evaluating and investing in no-load mutual funds.
