Email: Isn’t my loaded mutual fund still good?
Here’s an email exchange I had over the weekend with someone about why loaded funds are one of the worst investments you can make. EVER!&*#%#
To: Ramit Sethi (ramit@stanford.edu)
From: Ashish D
Date: June 19, 2005Hi Ramit!
Just came across your website on a google search. Read a few of them, great articles!! I just had a question with regard to a managed fund, in a flat market don’t managed funds outperform index funds. I do agree that in the long run there are just a few funds that beat the indexes but wouldn’t investing in an index fund be at the risk of assuming that the markets would rise. Also if the expense ratio of a fund is 0.70% and the index equivalent fund is 0.20%, should I be looking to see that the managed fund beats the index by at least 0.50%?? I have all my funds in American funds and its been really hard for me to see any downside, as they continually outperform the indexes after the initial sales charge which is a front load 5.75%, am I missing something?? Thanks for your time. Take care.
ashish
My response:
To: Ashish D
From: Ramit Sethi
Date: June 19, 2005Hi Ashish,
Thanks for your email!
In terms of your question, index funds generally beat managed funds over the long term. And you can safely assume that the markets will rise for two reasons: First, they’ve consistently risen over the past 70 years (again, this is in an average year; some years they go down, and some they go up, but there has been a net average rise). Second, mutual funds also depend on the market rising! So you have to make that basic assumption in order to make money over the long term.
Also, if your fund’s expense ratio is really 0.70% for a managed fund, that’s very low and, yes, you should expect your fund to beat an index fund by at least 0.20% (0.50% managed fund minus 0.20% index fund). But I’ve rarely seen a managed fund’s expense ratio that low. Typically, managed funds’ expense ratios are 2-3%. As a result, if we assume the market returns 11% on average per year, your fund should return at least 13-14%. That level of consistent return is rare, which is why indexes typically beat mutual funds–again, over a long period of time.
I’ve written about mutual funds before:
http://www.iwillteachyoutoberich.com/archives/2005/01/all_about_mutua.html
http://www.iwillteachyoutoberich.com/archives/2005/05/how_mutual_fund.html
http://www.iwillteachyoutoberich.com/archives/2005/03/dont_some_activ_1.html
http://www.iwillteachyoutoberich.com/archives/2005/04/you_arent_good.htmlFinally, you’re paying a front-end load!? WHY? This is one of the most disgusting practices that financial-service companies have. They know it and, recently, consumers have started to know it too. Here’s how it works:
Front-end loads simply charge you some percent up front, right when you invest. Typically this is 5-8%. In other words, you’re paying a mutual fund 5-8% so they can “manage” your money and charge you even more. And you have to make 5-8% just to break even! This is one of the stupidest moves anybody can make.
Consumers started to realize this and got pissed, so the mutual-fund companies got smart and came up with an even more devious plan. They created the back-end load, a sinister creation, the likes of which I have never seen. This is a little confusing, but let me quote Suze Orman (I love her) in her introductory description of back-end funds:
I can’t tell you how angry this makes me…You see, the broker who sold you the fund probably received a 5 percent commission, paid by either the firm he works for or the fund itself, up front and in full when you made the purchase. The brokerage firm or mutual fund company gets its money back by charging you what is known as a 12(b)1 fee of anywhere from 0.75 to 1 percent yearly. This fee, which the SEC allows for “marketing” costs, is used to pay the cost of the broker and is taken out of the fund’s returns. So if your fund earns 10 percent, and your 12(b)1 fee is 1 percent, your return is only 9 percent, because the brokerage firm is taking that 1 percent to pay itself back for the broker’s commission. That is why your surrender fee goes down by 1 percent each year. Suppose your fund paid a broker 5 percent up front and they take 1 percent a year from your return. If you were to sell after one year, your surrender charge would be 4 percent. Add that to the 1 percent they already took, and they’ve recouped the money they paid the broker. Pretty sneaky, don’t you think? (Pg. 403)
(Btw, you mention that your fund consistently beats the indexes. Over 1 year? How about 5 or 10 years? Check on this.) Here’s a chart of how a loaded fund can negatively affect your performance. The results are pretty stunning.
In general, NEVER EVER EVER BUY A LOADED FUND. They may outperform an no-load fund or index fund, but there’s no guarantee of that. Instead, if you do pay a load, you’re simply making it harder for you to get the maximum returns you can. I like index funds best, but if you must buy a mutual fund, make sure it’s a no-load fund.
-Ramit
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