Financial Literacy - Financial tuneup
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Advice from the index-fund mastermind

The third cost is hidden, but we know it exists; we just don't know exactly how large it is. That's the portfolio turnover cost. Mutual funds turn over their portfolios at an astonishing rate, averaging about 100 percent per year. By my estimates, any fund that turns its portfolio over at that rate is costing you an extra 1 percent per year: a half percent to buy all those securities, including market impact costs, and a half percent to sell them. A 100 percent turnover means a billion-dollar fund buys a billion dollars' worth of stock and sells a billion. That's our definition of 100 percent, but that's $2 billion of transactions. You have to take into account that cost.

If you find lower-turnover funds, and very few funds turn over at lower than 30 percent per year, you're talking about not 1 percent per year, but about a three-tenths of 1 percent cost per year. In other words, the turnover rate with the decimal point moved over two places (0.003). So 100 percent turnover would cost 1 percent roughly. And a 30 percent turnover would cost three-tenths of 1 percent. So let's call it an average of seven-tenths of 1 percent per year for portfolio turnover.

So adding costs together, we have a 1.5 percent expense ratio, if you're paying a sales commission, another 0.7 percent on average for a seven-year holding period plus another 0.7 percent for turnover costs if you're average, so that adds up to roughly 3 percent. That's an astonishingly high cost and investors are almost oblivious to nearly all of it, but totally oblivious to the second and third costs. We've got to pay attention, or as we say in "Death of a Salesman," "Attention must be paid."

I usually estimate total costs at 2.5 percent; if someone wants to argue that's too high, say a minimum of 2 percent paid by the typical fund investor. If you don't like my estimates, knock them down a little bit.

How much to pay

q_v2.gifWhat's the highest expense ratio that one should pay for a domestic equity fund?

a_v2.gifI'd say three-quarters of 1 percent maybe.

q_v2.gifFor an international fund?

a_v2.gifI'd say three-quarters of 1 percent.

q_v2.gifFor a bond fund?

a_v2.gifOne-half of 1 percent. But I'd shave that a little bit. For example, if you can buy a no-load bond fund or a no-load stock fund, you can afford a little more expense ratio, because you're not paying any commission. You've eliminated cost No. 2.

One of the ironic things about this is if you want to eliminate turnover cost, the third cost I mentioned, it's like rolling off a log -- it's the easiest thing in the world: Buy an index fund.

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If you buy a no-load index fund, with an expense ratio of, say 0.15 percent a year, you've taken that typical 2 (percent) to 3 percent cost and reduced it by about 95 percent a year. And it's there for the taking. In the long run it's really quite certain, because the data show us that only about 5 percent of the managers will outperform the market over an investment lifetime.

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