Adding the Minuses

Adam M. Grossman

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:

Step 1: Track down a fund’s expense ratio. You can find the information on the fund company’s website, as well as on sites like Yahoo Finance and Barchart.

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:

  • Multiply a fund’s long-term capital gains distribution by your capital gains tax rate. Your capital gains tax rate will depend on your overall income level and whether you’re married or single, so you might ask your accountant for help, assuming you use one.
  • Multiply short-term capital gains distributions by your marginal income tax rate—that is, the rate that applies to your regular income.
  • If your state levies an income tax, do these same calculations with your state tax rates.

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:

  • Total fees and taxes of less than 0.20%: Excellent
  • Between 0.20% and 0.40%: Good
  • Between 0.40% and 1%: Fair
  • More than 1%: Unacceptable

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:

  • You could donate the shares to charity.
  • You could sell the fund in a year when you have an offsetting loss on another investment.
  • If you’re near retirement, you could hang on until your tax rate is lower.
  • You could give the fund to one of your adult children, whose capital gains tax rate might be lower—and perhaps even zero.
  • You could sell the fund. If this is the option you want to pursue, continue on to the next step.

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:

  • Determine the tax you’d owe if you sold. Again, if you use an accountant, you might ask him or her.
  • Divide that tax by the total annual cost of holding the fund. For the latter number, head back to Step 3.

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 NotPortfolio 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.

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