IT’S NO SECRET THAT mutual fund costs are critically important. In fact, when it comes to the performance of funds in the same category, they’re the single most important differentiator. In the words of Morningstar, the investment research firm, “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision.”
But how do you go about totaling up a mutual fund’s costs? And should you sell an expensive fund even when that sale might trigger taxes? Below is the approach I recommend:
When you’re looking up a fund’s expense ratio, be sure to look it up by ticker symbol rather than by name. That will ensure you’re looking at the share class for the fund you own, since different share classes usually carry different fees.
To put the expense ratio in dollar terms, simply multiply the dollar value of your fund holdings by the expense ratio. Let’s say a fund charges a 1% expense ratio. You’d need to convert that to a decimal by dividing it by 100, which would give you 0.01. If you have $10,000 invested in the fund, you would multiply that $10,000 by 0.01. Result: The fund is costing you $100 a year.
Step 2: If you hold a fund in a regular taxable account, you’ll also want to quantify its tax cost. This information is often overlooked because it’s harder to find, but this is the perfect time of year to look. In the coming weeks, as you receive 1099 tax forms for your mutual funds, check for the line that reads “capital gains distributions.”
Be warned: There’s an important distinction between capital gains on the sale of a fund itself—which is your choice and entirely voluntary—and capital gains generated by trading inside the fund, which is at the fund manager’s discretion and not your choice at all. It’s the latter type of capital gain—the “distributions”— that you want to examine.
Determining the tax impact of these distributions takes a little work. But in general, you want to do the following calculations:
Step 3: Add together the above expenses and taxes. If your fund’s expenses are $100 a year, and the taxes on capital gains distributions are $200, the fund is costing you a total of $300 per year.
Step 4: To put these numbers in context, divide your total cost by the value of your fund holdings. For instance, $300 divided by $10,000 equals 3%. To judge that figure, I would use these rules of thumb:
Step 5: In the above example, we calculated a total cost of 3% a year, which puts the fund squarely in the unacceptable category. If any of your holdings fall into this category, you have a few choices:
Step 6: Suppose you’ve determined that a fund is overpriced and you want to sell. If the fund isn’t in a retirement account, the sale might trigger a tax. How do you know if the sale would be worthwhile? I recommend this calculation:
This calculation will tell you how many years it would take to break even on the sale. For example, if the estimated tax bill from selling was $1,000, and your annual cost of holding the fund is $300, it would take you about three years to break even. If it were me, I would do this trade. But if the breakeven point were far longer—say 10 or 20 years—then I wouldn’t be as quick to sell. Instead, you might opt to hold on until you were ready to pursue one of the other options outlined in Step 5.
Keep in mind two caveats. First, you’ll notice that, in these calculations, I’m looking at the absolute cost of an investment and not comparing it to the cost of any alternative. This might seem unfair. But there are many investments today that are so low-cost and so highly tax-efficient that they’re virtually free—and thus I think that zero is an appropriate benchmark for comparison.
Second, I acknowledge that high expenses may be justified by a narrow slice of funds. But these outliers are mostly private equity, venture capital and sometimes hedge funds. What we’re talking about here are ordinary mutual funds, where high costs generally don’t correlate with better results.
Adam M. Grossman’s previous articles include Believe It or Not, Portfolio Makeover and The Wager Revisited. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.