Can You Do Mutual Fund Math?

Can you do the mathematical calculations required to find out how much your mutual fund is going to cost you? Chances are you might say yes, if you consider yourself a very savvy investor, able to filter all of the costs in the prospectus into a final number, understand the tax implications known and as yet unknown, and then be certain that you are right – or as close to right as humanly possible.

But chances are you can’t. Instead you fall squarely into the camp of investors who either have no clue or look at one guiding number and the vast majority of you are 401(k) or IRA investors as well. That number, widely advertised by the one group that lobbies in favor of mutual funds, Investment Company Institute or ICI comes in at an average of about 1.17% for all actively managed funds.

Most financial professionals, understanding that this is the average, suggest it as the top any client or interested investor should pay for the privilege of a little more risk than a simple index provides. Some also understand that this is more a moving target and unless they raise the cap to 1.5% as the max, they may exclude some of the better performing funds in the investment world, even at a slightly higher price.

And then along comes kaChing, a financial website that takes the next step in mutual fund muck-racking: they add in all of the factors a very math-smart investor might and suggests a number that is three times what the ICI believes it should be.

So who is right or are both or neither correct in their assumptions. Without too much math, you first have to realize what an actively managed fund does. A fund manager essentially trades to make gains. If they have done well, those trades generate taxes. If they trade at all, they generate fees. But how much is too much and aren’t taxes further proof that you are doing good?

kaChing’s look at the tax event adds almost a full percentage point to the mix. Keep in mind that taxes are levied on the shareholders whether you were in the fund at the time of the sale or not. The most commonplace warning is to avoid buying into a fund at the end of the calendar year. The same could be said for the end of the quarter.

If you are in the fund, and the fund has done poorly as most did in 2008, your fund manager scrambled to pay those that were fleeing (as folks do when things are bad, the most common mistake made by investors both savvy and not), and in doing so, some profitable investments were sold. This “stop-the-bleeding” sale of what the fund manager would have otherwise simply waited out in the downturn creates taxes. And because we are in it together, we all pay.

It isn’t fair that some new investors have to pay these taxes and it is incredibly unfair that those who stayed in the fund have to pay as well. But, you can pile those complaints in with the risk one takes.

(If those selling in a panic could be charged the 1% for future taxes that might be incurred, perhaps we wouldn’t feel so bad. But then the fund would essentially be a closed-end fund at that point, penalizing everyone, tax event or not.) ICI doesn’t make a tax prediction suggesting that your withdrawal tax rate is the only thing really worth considering.

ICI does however suggest a trading cost, but because most of their calculations are based on a fund’s weight (kaChing considers all funds as equals when determining fees, whether you have ten billion in holdings or just a couple of million). Size matter when it comes to costs for trades and other services.

So which is it? kaChings inflated but closer to accurate representation of what a fund really costs? Or ICI’s brush with weighted averages to drive the number down?

Neither. If you are using funds for your retirement, and the vast majority of us do, these numbers are deferred to some future time. I think that knowing exactly what that tax rate will be – perhaps a fixed rate up to a certain distribution amount would be the best thing to draw a bead on what you will need. A plan administrator should be shopping for the lowest fees and from there, you make the call.

If you are using funds outside or in a tax deferred account, use the kaChing number instead. I would think that it would be better to be pleasantly surprised to the downside, than vice versa.