Fund Managers Are Good Stock Pickers But Expenses Kill Returns

by Alan Lavine and Gail Liberman

Want to outperform the market with actively managed stock funds? The task is tougher today. The reason: mutual fund management fees are on the rise, according to a study by Lipper Inc., a New York research firm.

Management fees range from .2 percent to more than 3 percent annually. The fee is deducted from a fund's earnings before it is passed on to shareholders. The higher the management fee, the less that winds up in your pocket.

It's true that mutual fund managers may deserve these fees because they know their business. A study by financial economist Russ Wermers, Ph.D., finance professor at University of Maryland, College Park, revealed that after a fund manager purchases a stock, that stock outperforms the S&P 500 by almost 1 percent annually. After a stock is sold, it tends to underperform the market by about 1 percentage point annually.

Other studies by John Nofsinger, Ph.D., a professor at Washington State University, Pullman, and author of Investment Blunders, (Financial Times Books), found similar results. The stocks most purchased by professional money managers in one year outperformed the market by more than 3 percent the following year. The stocks sold by managers declined -2.4 percent the following year.

If these investment managers are so good, what happens to our own mutual fund investments? A chief problem is that fund expenses result in lower returns. The average stock fund, which sports an expense ratio of 1.45 percent, grew at an 8.03 percent annual rate over the past 10 years ending in September 2002, according to Morningstar Inc., Chicago. That's nearly three-quarters of one percent less than the S&P 500, which grew at a 9 percent annual rate. In part, this is due to fund expenses.

"The costs mutual fund companies impose are too high to overcome with their superior ability," Nofsinger explains. "Given this relationship, investors should be very diligent in picking mutual funds with low costs."

Fees cut into your returns even more if you hire someone to manage your mutual funds. A financial adviser may charge another 1 percent to 2 percent annually, depending on how much you invest. When you pay all those fees, don't expect to beat the market. That's why it's critical that a financial professional earn his or her fees by at least examining your goals and cash flow needs. The pro also should help you reach your goals by putting you in the least risky investments possible.

Alan Lavine and Gail Liberman are husband-wife personal finance columnists, journalists and authors. They are the authors of "The Complete Idiot's Guide to Making Money with Mutual Funds," published by Alpha Books. Their columns appear in newspapers throughout New England and the Southeast, as well as online. Their commentary on mutual funds and personal finance is carried by 200 radio stations nationwide every Sunday over Business News Network's Charles DeRose Financial Advisor Show.

More articles by Al and Gail can be found here.