Contents
Mutual Fund Basics
Why Invest in Mutual Funds?
Mutual Fund Returns
Types of Mutual Funds
Mutual Fund Investment Holdings
Funds vs. ETFs, Stocks, and Bonds
How to Plan a Mutual Fund Portfolio
How to Research Mutual Funds
How to Buy Mutual Funds
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Mutual Fund Returns
An investment’s return is the increase or decrease in the investment’s value over a set period of time. Returns are typically expressed as an annual percentage. For instance, a 10% return on a $1,000 investment would equal $100. This gain of $100 added to the original investment, or principal—in this case $1,000—would give the total investment a value of $1,100. A return of −10% would mean that $100 of the principal was lost, reducing the value of the investment to $900 after one year.
Several different types of returns come into play with mutual funds, and understanding how they differ is crucial to successful investing. The three types of returns are:
- Total return
- Total return after taxes
- Total return after taxes and expenses
Total Return
The total return, or annual return, of a fund represents the raw percentage increase or decrease in a fund’s net asset value (NAV). A fund’s total return is the number that mutual fund companies mention when touting their funds’ performance in advertisements. But total return is often misleading as a measure of performance because it doesn’t take into account the impact of taxes and expenses on the fund’s performance, which can reduce the total return substantially. In other words, two funds with identical 10% total returns may not actually pass on to you, the investor, the same amount of money.
Total Return After Taxes
As an individual investor, you typically must pay taxes anytime your investments generate income for you. Investments generate income in three ways:
- Interest: Cash payments that banks and bonds pay out to investors in exchange for the right to borrow and use the investors’ money. Interest is taxed as ordinary income, at a rate ranging from 10–35% depending on your tax bracket.
- Dividends: Cash payments that publicly traded companies issue to their shareholders. As of 2007, most dividend income is taxed at 15%.
- Capital gains: Cash profits you receive when you sell an investment for more than you paid to buy it. Long-term capital gains (gains on investments held for more than one year) are taxed at 15%. Short-term capital gains (gains on investments held for less than one year) are taxed as ordinary income, at a rate ranging from 10–35% depending on your tax bracket.
Mutual funds incur a tax liability every time their investments generate interest, dividends, or capital gains. Unlike individual investors, though, mutual funds don’t pay taxes—their shareholders pick up the tab for them. The total return after taxes, also called the after-tax return, is the return an investor should expect to receive after paying taxes on his or her portion of the fund’s interest, dividends, and capital gains. Since everyone’s tax situation is different, fund companies publish approximate after-tax returns based on the average investor’s tax bracket.
Tax-Efficient Funds
Fund companies have responded to investors’ concerns about the impact of taxes on total returns by offering tax-efficient funds, also called tax-managed funds. These funds function in such a way as to generate as small a tax burden as possible. They accomplish this in two ways:
- They invest in securities that pay dividends, rather than interest, to take advantage of the low 15% tax rate.
- They limit the turnover of the fund’s portfolio. Turnover refers to the frequency at which a fund sells securities that it holds. A higher turnover rate often results in higher tax bills, since capital gains on investments held for less than one year are taxed at ordinary income tax rates—higher than 15% tax on long-term capital gains.
Fund companies often offer tax-efficient versions of their popular funds. Why would an investor not buy the tax-efficient version? The most common reason is that they already own their funds in a tax-advantaged retirement account, such as a 401(k) or IRA, and therefore don’t need the tax protection.
Total Return After Taxes and Expenses
A mutual fund’s total return after taxes and expenses is the number you should pay closest attention to when selecting funds—it’s the only return metric that reveals the return you should expect to make on your money after all taxes and expenses are taken into account. Predictably, most fund companies bury this metric in fine print and instead broadcast their considerably higher total returns or total returns after taxes, which don’t include expenses.
The Expense Ratio
Running a mutual fund costs money. Expenses include everything from fund manager salaries to transaction costs for buying and selling securities, and from legal and accounting fees to office supplies. Usually it’s not the fund that foots the bill for these expenses—it’s the shareholders.
A fund’s expense ratio is an annual fee, expressed in percentage terms, that’s charged to shareholders to cover the fund’s overall operating expenses. The fee is expressed as a cumulative percentage, such as 0.97% or 2.21%, but funds deduct each investor’s portion of expenses daily. For instance, if you own $1,000 worth of a fund with a 1.50% expense ratio, you’ll pay $15 a year in expenses, which will be deducted from your account in increments of about $0.04 per day.
How Expense Ratios Impact Fund Returns
Many investors disregard expense ratios because the fees they charge seem so small. This mistake can cost thousands of dollars over time. Consider the impact of expense ratios on $10,000 invested for 20 years in the two funds below:
Fund A |
Fund B |
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Expense ratio |
0.18% |
1.50% |
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Annual rate of return |
10% |
10% |
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Value after 20 years |
$65,107.17 |
$51,120.46 |
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Expenses paid |
$1,010.11 |
$7,256.55 |
Though the ratios differ by only 1.32%, over 20 years that difference adds up to $6,246.44 in additional fees.
How to Mitigate the Effect of High Expense Ratios
Many investors avoid investing in mutual funds altogether because alternative investments, such as individual stocks and bonds, impose no expenses beyond transaction costs. There are three reasons why this approach doesn’t always make sense:
- Volatility: Stocks and bonds are often much more volatile than mutual funds. Volatility refers to how often an investment’s value fluctuates over a given time period. Though mutual funds certainly can lose value over time, they generally tend to experience less severe price fluctuations than the wild swings that can come with owning individual securities.
- Time and knowledge: Many investors lack the time and knowledge required to research and select individual stocks and bonds, or other investments. Mutual funds remove this burden by shifting the responsibility for picking stocks and other securities to the fund managers. Though some investors prefer not to surrender control to fund managers, many consider the convenience to be well worth it.
- Inexpensive funds: Contrary to popular belief, mutual funds with high expense ratios do not always “pay for themselves” with stellar total returns. It’s easy to find funds that carry low expense ratios and consistently beat most of the funds with high expenses. One of the best sources for such low-cost mutual funds is the Vanguard Group (www.vanguard.com)—many Vanguard funds have expense ratios below 0.50% and routinely match, or beat, the performance of funds that charge 1.50% or more (for more on inexpensive funds, see Types of Mutual Funds).
A Case Study in Mutual Fund Returns
The best way to understand the impact of taxes and expenses on fund performance is to take a close look at some actual numbers. The table below shows the impact of taxes and expenses on a $1,000 investment in the Vanguard 500 Index Fund® held from June 2005 to June 2006.
Return Type |
Return |
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Total return |
8.49% |
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Total return after taxes |
5.90% |
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Total return after taxes and expenses |
5.72% |
The difference between the fund’s total return and the actual return you might expect to earn is 2.77%—so rather than pocket a gain of $84.90 (based on the total return), you’d earn only $57.20 (based on the total return after taxes and expenses). In light of these numbers, keep in mind:
- When comparing funds, don’t compare only total returns or expense ratios—focus instead on total returns after taxes and expenses.
- Taxes and expenses have a major impact even on funds with very low expense ratios: a fund that’s cheap to own (due to its low expense ratio) may not be cheap to sell (due to impact of taxes and expenses over time).
Where to Find Fund Return Data
In 2001, the Securities and Exchange Commission (SEC), the U.S. government agency that regulates the investment industry, began to require fund companies to disclose after-tax returns in addition to total returns (though not total return after taxes and expenses). To find after-tax return info, consult the fund’s prospectus, a report that contains all of the information about a fund that fund companies are required to publish.
Prospectuses are available online for free. You can also order them via phone or mail directly from fund companies, usually at no charge. If the prospectus doesn’t include data for total return after taxes and expenses, you can calculate total return after taxes and expenses by subtracting the annual expense ratio percentage from the after-tax return.
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