Fund Costs

John Flaherty: “I just discovered your mutual fund calculator from a mention in this morning’s Boston Globe. It’s very useful. But there’s something about fund comparisons that has always puzzled me. Although I understand the implications of loads and fees on the overall performance of a fund, doesn’t it stand to reason that even with say, 3% higher expense fees, a person will make out better in a fund that has a 25% return over a fund that has, for example an 8% return?”

Absolutely. Just find a fund that goes up 25% a year and you’ll never have to worry about fees. Indeed, if you start off with $25,000 and hang in there for 75 years somehow — transplants! aerobic mall walking! — it will grow to nearly half a trillion dollars.

The problem, of course, comes in finding funds that will do better than average, let alone anything even remotely that much better than average. Looking back, you will find a few that have. But you are not trying to find funds that have, you are trying to find funds that will. Quite a different thing.

The purpose of the calculator is simply to help you focus on how much better than average a fund manager has to do in picking stocks just to cover the transaction costs of his trades plus the management fee he charges you.

My own feeling is that a manager who can fairly consistently out-pick his colleagues by 3% a year (his 12%, say, to their 9%) is a rare and wonderful talent. But if he incurs an extra 1.5% a year in transaction costs with all his maneuvering, and if he charges you 1.5% in management and 12b-1 fees, then what has he really accomplished? The 3% stock-picking edge is eaten up before it enriches you.

(Note that in this example, that 3% is actually outdoing his colleagues by 33%. Right? A 12% return is a third higher than a 9% return. So it may sound fairly small, but it’s not.)

How We Handle Taxes

Our calculator also shows the rather dramatic effect taxes can have on your net after-tax results. Some funds are significantly better “tax-managed” than others. Index funds, for example, may be reasonably expected to expose their owners to very light tax burdens.

But our tax projections should be taken with two very large grains of salt.

First, our calculator projects future years’ tax burdens based on the last year’s burden. That’s OK if this last year was more or less a “typical” year for the fund (if there even is such a thing). But after a year of outsized realized gains and high tax exposure (or a bad year, with no realized net gains and no taxes), it will lead to crazy projections.

Second, just because one fund exposes you to a lot more tax than another doesn’t mean that your gains in the other won’t eventually be taxed.

They could remain forever tax-free if you should choose to use your appreciated mutual fund shares to do your charitable giving. Or if you should die without having sold them. (In that case, under current tax law, your heirs would get a “step-up in basis” to the value of the shares as of the date of your death. So try to go out on an up day.)

But if you eventually sell your appreciated mutual fund shares, you will owe long-term capital gain tax on the appreciation. And our projections do not reflect that tax. (Plus, it’s certainly possible that a tax-efficient fund, piling up unrealized gains, would one day take some of those gains — although this is somewhat less likely for an index fund than an actively-managed fund.)

So the advantage of tax-deferral is real — you get “the government’s” share of your money working for you for many years alongside your own — but it may well not be a completely free ride. At the end, when you sell, you do have to fork over some of the gain. And that tax bite is not included in our projections.

(But you can get to it. Just proceed through our analysis until you get to our “Dump This Fund?” tool. There, choose a fund to compare yours with and click GO. In the second field where we ask for the “cost basis” of your shares, enter the same number that’s already in the first field. Now click GO again. Scroll down the page that appears and you’ll see, year-by-year, how your fund will grow before and after tax. It’s even smart enough to properly account for the basis of reinvested distributions.)