Publication: Investor's Notebook
URBAN LEGENDS IN MUTUAL FUNDS | |
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Investor's Insight - Wednesday, March 8, 2006
"A Digest of Investment Opinion From the
World's Leading Financial Advisers"
Comment The Post Below...
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URBAN LEGENDS IN MUTUAL FUNDS
by Scott Burns
"My husband had a hallway conversation with a financial
planner who shares an office building with him. The plan-
ner said something like, 'Index funds can cost more than
load funds because people can buy and sell in and out of
the index fund. This triggers transaction costs of buy-
ing and selling stock that have to be paid by the index
fund. Whereas with the load fund, people tend to stay in
it longer. The fees are higher in the load fund, but the
transaction costs are lower.'
"My husband and I got in a big conversation about this.
I thought it was ridiculous. First I asked if the guy
sold load funds, and my husband said he didn't; he gave
fee-based advice only.
"I said that probably the index funds have some kind of
pooled cash or shares. And every time someone buys or
sells 100 shares of the index fund, they don't actually
have to buy or sell individual shares of stock in and
out of the fund. Some people sell; some people buy. It
all evens out."
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So wrote N.B., a reader in Washington state, of an en-
counter with an enduring story often told by people on
the sales side of the mutual fund business.
The actual facts, which are as available to those in
financial services as they are to financial journalists,
are quite different.
First, the broad index funds have portfolio turnover
rates that are small fractions of turnover rates in man-
aged funds. According to Morningstar, for instance, the
average turnover rate for all managed, large-blend dom-
estic equity funds is 85 percent. The average turnover
rate for all managed, large-blend domestic equity funds
with front-end loads is 74 percent. The average turnover
rate for all managed, large-blend domestic equity funds
with deferred loads is 73 percent.
This adds a lot of expense.
The average turnover rate for all index funds in the
same category is only 18 percent. The turnover rate in
the 10 largest index funds in the category ranges from
a low of 2 percent (the SPDR exchange-traded fund that
replicates the S&P 500 index) to a high of 5 percent
for Vanguard Institutional Index fund and Fidelity
Spartan U.S. Equity fund. Only 148 of the 1,888 managed
domestic funds, or 7.8 percent, have turnover rates of
5 percent or less.
So if there is an expense burden due to portfolio turnover,
the liability is on the side of managed funds. Indeed, low
portfolio turnover cost is one of the major advantages of
broad index funds.
Another advantage of index funds is that they seldom have
as much cash in their portfolios to meet redemptions as
managed funds, though the difference isn't great. The
Morningstar data for the same group shows that managed
funds had 3.7 percent of their portfolios in cash, while
index funds in the same category had 2.7 percent of their
portfolios in cash.
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Similarly, most of the major fund firms now charge fees
that discourage short-term trading, whether the fund is
managed or an index. Fidelity, for instance, charges a
fee of 0.50 percent if shares of its Spartan 500 Index
fund are sold within 90 days of purchase. The fee is
paid into the fund, not to the fund company. The idea
is to protect long-term investors.
Vanguard does not allow purchases within 60 days of a
fund sale for some funds and, like Fidelity, imposes a
redemption fee that is paid into the fund for some funds.
Whatever the relative cost of managed vs. index funds, it
has been argued that investors in load funds have advisers
who encourage them to hold. Self-help investors frequently
change their minds and fail to reap the advantages of long-
term performance.
That's an issue that may concern self-directed investors.
As I have said many times, indolence pays.
(Investor's Insight reflects the opinions of experts. It does
not recommend any specific investments, and no endorsement is
implied or should be inferred. For more information, contact
the individual firms cited).
COPYRIGHT 2006 UNIVERSAL PRESS SYNDICATE
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