Best No Load Mutual Funds: The Right Way to Look at Fees and Expenses
by Sam Subramanian of AlphaProfit.com

When searching for the best no load mutual funds, some mutual fund investors often tend to focus exclusively on mutual fund fees and expense ratios. Is this always a smart way to select mutual funds?

Metrics such as price/earnings ratio and dividend yield on the S&P 500 index, a commonly used proxy for the U.S. stock market, are hardly at bargain levels. This has lead several market pundits to predict single digit annual returns for domestic mutual funds over the next decade.

While pursuing the search for the best mutual fund, some mutual fund investors tend to focus exclusively on fees and expense ratios. The rationale is that by choosing mutual funds with low fees, investors will have more of their capital invested. Also, no load mutual funds with low expense ratios will pass on more of the returns they earn to their shareholders.

Is shopping for the lowest fees and expense ratios a smart way to select mutual funds? Not always. The answer depends on the type of mutual fund you are evaluating, the time you can devote to evaluating and managing your mutual funds investments, and the type of cost incurred.

Investing in the Best No Load Index Mutual Funds.

If you believe markets are generally efficient and prefer to invest in an index mutual fund to achieve an index-like return, shopping for the best index mutual fund based on low fees and a low expense ratio makes good sense. The portfolio manager of an index mutual fund endeavors to invest the fund's assets to track the index as closely and cost-effectively as possible. Larger index funds have an advantage in that they can spread their operating costs over a larger asset base.

Some of the interesting index mutual fund options currently available include no load index mutual funds like E*Trade S&P 500 Index Fund (Nasdaq: ETSPX), Fidelity Spartan 500 Index Fund (NASDAQ: FSMKX), and Vanguard 500 Index Fund (NASDAQ: VFINX) with expense ratios of 0.09%, 0.10%, and 0.18%, respectively.

Investing in Actively Managed Mutual Funds and Strategies.

Mutual fund fees and expenses are just one of several important factors to consider if you believe portfolio managers can add value and outperform the index through active management. The portfolio manager's ability and investing style are just as important. Therefore, seeking out the best mutual fund based on just low fees and a low expense ratio may not always be the right approach. It may just be a case of being 'penny-wise and pound-foolish'.

Legendary investor Peter Lynch, who managed the Fidelity Magellan Fund (NASDAQ: FMAGX) from 1977 to 1990, achieved returns well in excess of the market averages even after accounting for the fund's fees and expenses.

So too has Bill Miller who currently manages the Legg Mason Value Trust (NASDAQ: LMVTX). Even after accounting for its relatively high 1.7% expense ratio, this no load mutual fund has achieved compound annual returns of 18.6% for the 10 year period ending in 2004, well in excess of 12.0% for the Vanguard 500 Index mutual fund.

AlphaProfit, an investment research firm that specializes in active sector investing, uses the no load Fidelity Select Funds to implement its investing strategy through its Core™ and Focus™ model portfolios. Although not the lowest, the expense ratio of the no load Fidelity Select Funds compares favorably with that of other sector fund offerings. AlphaProfit prefers Fidelity Selects for their comprehensive coverage of sectors and industry groups. The AlphaProfit model portfolios have significantly outperformed the market averages over time.

Ensuring Your Mutual Fund Puts Your Interest First.

Whether you prefer to index or take an active approach to managing your investments, ensuring that your mutual fund is putting your interests first is good investing practice.

Mutual funds charge different types of fees. By looking at some key factors pertaining to fees, you can get a sense of whether the mutual fund puts your interests first or merely seeks to line the mutual fund company's pockets.

Serving the Interests of Long-Term Shareholders. Some mutual funds impose short-term trading fees to discourage frequent trading of mutual fund shares. Frequent trading disrupts efficient management of the mutual fund and increases operating expenses. A short-term trading fee can therefore actually be beneficial to long-term shareholders if the fee is rightly treated by the mutual fund company.

Fidelity Spartan Total Market Index Fund (NASDAQ: FSTMX), for example, follows the practice of returning short-term trading fees collected on shares held less than 90 days to the mutual fund itself rather than passing on the benefit to the mutual fund company. By having this short-term trading fee structure, this no load mutual fund seeks to contain its operating expenses. Such fees are therefore aligned with the interests of long-term shareholders of this mutual fund.

Passing on Savings from Scale Economies. The operating expenses incurred by a mutual fund are a combination of fixed and variable costs. As the assets of a mutual fund increase, the fixed cost gets spread over a larger asset base. Therefore, the expenses incurred to operate the mutual fund as a percentage of the fund's assets should trend lower.

A mutual fund that places the interest of shareholders first must pass on the savings from scale economies to shareholders. The trend in a mutual fund's expense ratio therefore serves as a metric of how seriously a fund takes its fiduciary responsibility.

Key Points.

• If you are searching for the best no load index mutual fund, shopping for one with low fees and expenses makes perfect sense.
  
• If active management of investments appeals to you, fees and expenses are just one of several important factors to consider. The ability and investing style of the portfolio manager are at least just as important as fees.
  
• The types of fees a mutual fund charges and how the fund uses the fees provides clues as to how seriously a mutual fund takes its fiduciary responsibility. Mutual funds that impose fees to contain operating expenses and return fees to the mutual fund help protect the interests of long-term shareholders.
  
• Mutual funds that put the shareholders' interests first typically pass on savings from scale economies to the shareholders.
  
  

Sam Subramanian, PhD, MBA is Managing Principal of AlphaProfit Investments, LLC. He edits the AlphaProfit Sector Investors' Newsletter™, a publication that discusses investments using Fidelity mutual funds. For the 5 year period ending December 31, 2004, during which the Dow Jones Wilshire 5000 Total Market Index declined 6.9%, the AlphaProfit model portfolios increased by up to 186.2%, a compound average annual return of 23.4%. To learn more about AlphaProfit and to subscribe to the FREE newsletter, visit http://www.alphaprofit.com.

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