For a few years now, I have been telling everyone I know that investing in the stock market is a great way to grow your wealth. When I started my first full time job after college, I invested in the mutual funds under the company’s 401(k) plan. After a couple of years, I had some money left over and started investing in a taxable brokerage account as well. I think a good way to start investing is to go with low fee Index Funds. You can build a stable foundation and then branch out on dividend stocks, speculative stocks, bonds, real estate, and other investments later.
It can be very daunting to start investing in the stock market. When I first started investing, I didn’t know what I was doing at all. I just picked the funds that looked like it was doing well recently. Now that I’m older, I know this is the wrong way to go about it. When you buy funds that performed well last year, you are probably late to the party. The right way to start investing is to begin with low fee mutual funds/ETF from a solid company like Vanguard and Fidelity. But as a beginner, how do you know what is low fee?
Loads are fees that can be charged when you buy or sell a mutual fund. It’s a percentage of the amount you are buying or selling.
- Front-load fund. You pay a percentage of your purchase when you buy the mutual fund.
- Back-load fund. You pay a percentage when you sell the mutual fund.
- Constant-load fund. You pay out fees at a regular interval.
- No-load fund. You don’t pay a fee.
It’s pretty simple when we list them out – a regular investor should stick with no-load funds. The only encounter I had with loaded funds was when I talked to a financial adviser at my credit union. I’m sure he was making a nice commission from these funds because he was pushing them pretty hard.
Definition of Expense Ratio from Investopedia.com
A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual calculation, where a fund’s operating expenses are divided by the average dollar value of its assets under management. Operating expenses are taken out of a fund’s assets and lower the return to a fund’s investors.
Basically, this is how much fee you are paying annually to invest in a mutual fund.
Rule of thumb
I read somewhere that investors shouldn’t buy a fund that charges more than 1.5% expense ratio. My rule of thumb is to keep the expense ratio under 1%. However, even 1% is expensive. It doesn’t sound like much, but if you have $100,000 invested, you’ll pay $1,000 per year in fee. That’s a lot of money and it will eat into your return on investment (ROI.)
Some funds are more expensive than others. I made a small table to help beginners. I’m sure it’s not complete and if you think I should add something, let me know.
|Lower Expense Ratio||Higher Expense Ratio|
|Large Cap (NASDAQ)||Small Cap (Russell 2000)|
|Passively Managed Funds (Index)||Actively Managed Funds|
|US Funds||International Funds|
|Developed Countries||Emerging Markets|
If you want to invest in international market or small cap, you’ll be paying more fees. It’s more work to run these funds.
Are you paying a lot of fees?
How can you tell if you are paying a lot of fees? That’s hard to answer, but here is what I do. I check the fund symbol on Yahoo! Finance and go to the Profile tab. Let’s take a look at MFS Emerging Markets Equity A. (This A means it is a front-load fund.)
|* Per $10,000 invested|
We can see that the expense ratio is quite high at 1.66%. This is just a tad higher than the category average, but I don’t think we should pay anywhere close to the average. I like to keep the expense ratio at less than half of the category average, but it’s your decision. Take a look at the 3 years expense projection. That’s over 10% of the initial investment of $10,000. The fund would have to do very well for the investor to make a profit.
Let’s compare MEMAX to the Vanguard Emerging Mkts Stock Idx Adm, VEMAX. This is the Admiral share and you need to invest at least $10,000. Alternatively, you can go with VWO, an ETF.
|Fees & Expenses||MEMAX||VEMAX|
|Annual Report Expense Ratio (net):||1.66%||0.20%|
|Prospectus Net Expense Ratio:||1.71%||0.20%|
|Prospectus Gross Expense Ratio:||1.72%||0.20%|
|Max 12b1 Fee:||0.25%||N/A|
|Max Front End Sales Load:||5.75%||N/A|
|Max Deferred Sales Load:||N/A||N/A|
|3 Yr Expense Projection*:||1,085||64|
|5 Yr Expense Projection*:||1,454||113|
|10 Yr Expense Projection*:||2,488||255|
Could MEMAX’s performance justify the much higher fee?
Here is the year to date chart comparing MEMAX to VEMAX. Click through to see larger chart.
We can see that MEMAX is doing a bit better than VEMAX so far in 2012.
However, the fee really eats into the ROI over the long term. VEMAX is doing much better when we extend the chart out to 6 years.
I wouldn’t mind paying the fee if these actively managed funds can blow the door off the Vanguard Index Funds, but most of them can’t compete with Vanguard over the long haul. The high fee just goes toward the fund manager’s new yacht.
Did you notice this fee in the tables above? This is another fee and you probably should avoid the funds with any 12b1 fee.
Go with Index Funds
This is why I think most beginning investors should start with low fee index funds. Have you checked how much you are paying to invest in the stock market lately? For me, seeing 0.8% didn’t make a big impact. It’s when I found out through Personal Capital (free) that I’m paying $1754.91 in fee that I woke up and started the 401(k) rollover process.
For the research on this article, I picked MEMAX because MFS was the crappy fund family the aforementioned “financial adviser” sold me when I first started investing.
Disclosure: I am not a financial adviser and I’m writing this from my personal experience. You should do your own research and/or consult a professional before investing in the stock market. I am NOT an expert. I have no position in MEMAX and VEMAX. I have position in VWO. I may get a referral fee if you sign up with Personal Capital.