Many factors go into picking a mutual fund, says the Institute of Certified Financial Planners (1-800-282-PLAN).
"These criteria include the type of fund, its investment objectives, its track record, its management, economic outlook and so on. But one factor often overlooked by investors that can make a significant difference in performance is the fund's expense ratio."A fund's expense ratio is not its load. The load is the sales charge paid each time you put money into (or in some cases take money out of) a mutual fund. While many mutual funds don't have loads, all have expense ratios, which is the percentage of a fund's net assets that goes annually to cover management fees, transaction costs, administrative overhead, legal and auditing fees, and marketing costs (known as 12b-1 fees). To find out what a fund's expense ratio is, look at its prospectus under the heading "Annual Fund Operating Expenses."
Unlike the one-time load, annual expenses are an ongoing and somewhat invisible cost that, if high enough, can drag down a fund's overall performance, notes the Institute of Certified Financial Planners.
"One recent study of fund performance found that a $10,000 investment in two no-load funds, each earning 9 percent over 20 years, would grow to $30,475 in the fund with a 3 percent expense ratio and $45,840 in the fund with a 1 percent expense ratio."
Expense ratios often have the greatest impact on the performance of bond funds. This is partly because bond funds historically have been less volatile than stock funds, and returns vary less among similar types of funds, such as tax-free municipal bond or short-term corporate bond funds, than they do in a stock fund category where management can be more active.
A recent study by CDA/Wiesenberger found a direct correlation among 100 funds that invested in longer-maturity government bonds. The 25 funds with the highest five-year average annual expenses (1.57 percent) had the lowest five-year average annual return (8.66 percent). The 25 funds with the lowest average expenses (0.53 percent) had the best returns (9.91 percent).
Because many costs remain fixed regardless of the size of a fund, expense ratios tend to be lower for larger funds.
"Expenses also tend to vary widely depending on the type of fund. For example, international funds usually have higher transaction and administrative costs than domestic index funds. Specialized funds, such as precious metals or small company stocks, tend to have higher expenses."
So it's important when picking funds to compare expense ratios in similar-type funds. Look for funds with above-average performance and below-average expenses, advises ICFP.
"However, don't pick a fund solely for its expense ratio. One fund may have a high expense ratio but also have consistently superior performance because of the abilities of an active management.