Investing

Investing: Beware the low-return, high-expense fund

You can't measure a mutual fund simply by absolute performance — in other words, whether it's the best of all funds or not. Some years, for example, all international large-company stock funds may post a loss. The best funds, however, lost the least.

To see who's good and who's bad, look at how a fund has done compared with other funds with similar investment objectives. To find the best and worst, we looked at three time periods — one year, three years and five years — and ranked the funds with their peers.

To make the Big and Bad list, a fund had to be in the bottom 25% of its category for all three time periods. The fund categories are determined by Lipper, a trusted source of mutual fund data.

Past performance, as the Securities and Exchange Commission is fond of reminding investors, doesn't predict future returns. It's entirely possible that these funds could turn around tomorrow and be world-class winners.

But it's not likely, because these funds also lard on the expenses. Fund management takes a percentage of the fund's assets every year to pay for salaries, distribution costs and other expenses. Clearly, the more management takes, the less you keep.

Think of it another way: Many fund managers struggle to beat their benchmark index, such as the Standard & Poor's 500-stock index, by just 1 percentage point a year. Giving up a full percentage point each year in expenses makes beating a fund's benchmark all the harder.

"Expenses are the one constant you know is going to have an effect on performance," says Russel Kinnel, director of mutual fund research at Morningstar, the Chicago investment trackers. "High costs hurt you every year."

High expenses are particularly annoying at large funds, because the cost of running a fund doesn't grow proportionately with size. The average expense ratio of the 25 largest U.S. stock funds is 0.57%, Morningstar says. Even if you toss out the low-cost Vanguard funds, which have a different structure than most fund families, the 25 largest funds have an average expense ratio of 0.66%.

The funds with the worst five-year records are in the chart. You can find the rest online at www.usatoday.com.

Should you sell all of these funds? If you have a loss and you're in a taxable account, it couldn't hurt. You can use your losses to offset an unlimited amount of gains. If you still have losses after offsetting gains, you can deduct $3,000 from your income, and carry any remaining losses into the next tax year.

If you feel seller's remorse, you can buy the fund back after 30 days. If you don't wait 30 days, you'll have a wash sale, and the IRS will disallow it on your tax return.

What if you take a contrarian view, and decide that these funds might be ripe for a rebound? Possibly. After all, there's nowhere to go but up.

A large, fee-heavy fund can generate a powerful incentive for the fund company to find a better manager. A $10 billion fund charging 1.5% a year will generate about $15 million a year in gross revenue. If the fund shrinks to $1 billion, management's revenue shrinks to $1.5 million.

It may be that fund management has noticed the same thing you have, and replaced the manager. For example, Invesco Constellation replaced its management team in March 2011.

Look for a few things before you sink money into a big, bad fund. "It may be that the fund's style isn't in sync with the other funds," says Kinnel. This could be true. Growth funds that don't own Apple, for example, probably lagged other growth funds. That may indicate a fund manager is cautious rather than unskilled.

The simplest — and cheapest — solution is to buy a low-cost index fund, which dispenses of management entirely. But even an average fund is probably better than a long-term laggard.

more @ http://www.usatoday.com/money/perfi/columnist/waggon/story/2012-08-30/mutual-fund-expenses/57449506/1