WhitmanTrading

Mutual Funds: The Fee Must Be Beaten

A mutual fund pools money and is priced once daily after the market closes, so you deal at a price you cannot see when you order. Most are actively managed, which is what the higher fee pays for, and that fee has to be overcome before any value is added.

How it works

A candlestick chart of the site's shared price history. The headline on the chart reads: A pooled fund priced once a day, after the close.
A pooled fund priced once a day, after the close. Illustrative chart - not real market data.

A mutual fund pools money from many investors and prices once a day. After the close, the fund values everything it holds, divides by the units in issue, and that figure is the price everybody dealt at.

A gently rising stretch of the long price series with an account equity curve beneath it. The headline on the chart reads: You deal at a price you cannot see when you order.
You deal at a price you cannot see when you order. Illustrative chart - not real market data.

Orders are forward-priced. An instruction given at nine in the morning is executed at a price calculated hours later, which removes any possibility of intraday timing — a limitation and, for a long-term holder, a mild protection against fiddling.

A calmly advancing stretch of the long price series with an account curve that tracks a coin flip. The headline on the chart reads: Most of them pick, which is what the fee pays for.
Most of them pick, which is what the fee pays for. Illustrative chart - not real market data.

Most are actively managed. A manager and a research team choose the holdings, and that apparatus is what distinguishes the product and what the higher fee funds.

The fee has to be beaten

A 72-bar candlestick section of the shared price history with an account curve shown with and without fees. The headline on the chart reads: And one and a half per cent costs 36.5% over thirty years.
And one and a half per cent costs 36.5% over thirty years. Illustrative chart - not real market data.

A one and a half per cent annual charge removes 36.5% of a thirty-year pot, compounding the fee alone. A five basis point tracker removes 1.5%.

A flat, quiet stretch of the long price series with a slowly rising equity curve beneath it. The headline on the chart reads: The fee has to be beaten before anything is earned.
The fee has to be beaten before anything is earned. Illustrative chart - not real market data.

Which sets the hurdle precisely. A manager charging 1.45% more than a tracker must beat the index by 1.45% a year, every year, before the investor is level. That is the comparison, and it is arithmetic rather than opinion.

A strongly rising stretch of the long price series with a gradually rising equity curve beneath it. The headline on the chart reads: Some still charge an entry fee on top of the annual one.
Some still charge an entry fee on top of the annual one. Illustrative chart - not real market data.

Some funds still charge an entry or exit fee. A load taken on the way in is money that never gets invested at all, and it is separate from the annual charge.

A declining stretch of the long price series. The headline on the chart reads: A closet tracker charges active fees for an index.
A closet tracker charges active fees for an index. Illustrative chart - not real market data.

A closet tracker is the worst version. A fund whose holdings barely differ from its benchmark, charging active fees for an index return — the fee is certain and the deviation that might justify it is not there at all.

In practice

A choppy, directionless stretch of the long price series. The headline on the chart reads: And a fund's own trading can create a tax bill for you.
And a fund's own trading can create a tax bill for you. Illustrative chart - not real market data.

In a taxable account the fund’s turnover is your problem. Gains realised inside the fund can be distributed to holders, so a fund that traded heavily can generate a tax bill in a year you did nothing.

A candlestick chart with a volume histogram beneath it, with the volume histogram emphasised. The headline on the chart reads: It never trades on an exchange, so there is no spread.
It never trades on an exchange, so there is no spread. Illustrative chart - not real market data.

There is no bid-ask spread. Volume in an exchange-traded fund decides its dealing cost; a mutual fund has no market of its own, so that particular cost does not exist.

A long-horizon candlestick view of the same price series. The headline on the chart reads: It suits a monthly contribution and nothing faster.
It suits a monthly contribution and nothing faster. Illustrative chart - not real market data.

The structure suits regular contributions. Buying a fixed amount each month at whatever the daily price turns out to be is exactly what the pricing mechanism is built for.

A candlestick series containing several opening gaps, with the largest opening gap marked. The headline on the chart reads: An order placed at nine prices at the close.
An order placed at nine prices at the close. Illustrative chart - not real market data.

A gap during the day is fully reflected in the price you get. There is no sell-before-the-close option; the day’s move is yours whether you liked it or not.

A declining stretch of the long price series, with the entry price and the level at which a stop would trigger drawn as horizontal lines. The headline on the chart reads: There is no stop order, because there is no live price.
There is no stop order, because there is no live price. Illustrative chart - not real market data.

No stop order exists. With one price a day there is nothing for a stop to trigger on, which suits a long-term holding and rules the product out for anything shorter.

A candlestick chart of the site's shared price history, annotated with the round-trip cost. The headline on the chart reads: The underlying trades still cost a share of a bar each.
The underlying trades still cost a share of a bar each. Illustrative chart - not real market data.

The fund’s own trading costs are real and mostly invisible. Every position the manager changes pays a round trip — 2% of a median bar’s range on this history — and those costs sit inside the returns rather than in the published fee.

How to judge one

Three questions settle most of it. What does it charge in total, how different is it from a cheap tracker of the same market, and how long is the record. A fund that is expensive and barely different from an index has already answered the question, and that combination is more common than the marketing suggests.

On record length, the honest threshold is uncomfortable. Distinguishing skill from luck in fund returns takes many years of data, and three or five good ones is not enough to tell them apart. Which is why the fee — certain, known in advance — deserves more weight in the decision than the past performance figure that is usually presented first.

Share classes are the detail that catches people, and they are invisible from the fund’s name. The same portfolio is frequently sold in several versions charging different amounts, depending on how it was bought and how much was invested. Two people can hold the identical fund and pay materially different fees.

The cheapest class is usually the institutional or clean one, and access to it depends on the platform rather than on the fund. Checking which class you hold takes a minute and occasionally saves half the annual charge — a saving that requires no view about markets at all.

What a mutual fund is not

It is not tradeable intraday. One price per day.

It is not necessarily active. Index mutual funds exist and are cheap.

It is not free of trading costs. They sit inside the return.

And it is not judged by three good years. That is not a sample.

When it fails

A sideways, range-bound candlestick series. The headline on the chart reads: In a flat market the fee is the only certain outcome.
In a flat market the fee is the only certain outcome. Illustrative chart - not real market data.

In a flat market the fee is the only thing that definitely happens. A range lasting years produces roughly nothing from the market and a reliable annual deduction from the account.

The second failure is chasing recent performance. Money arrives after the good years, which means the average investor’s return is worse than the fund’s own published figure.

A third is a closet tracker. Index exposure at active prices.

A fourth is ignoring tax. Fund turnover creates liabilities in a taxable account.

And a fifth is comparing funds on headline fee alone. Loads, platform charges and internal trading costs are all outside it.

The original data

Compounding the annual fee alone over thirty years: five basis points removes 1.5% of the pot, twenty removes 5.8%, seventy-five removes 20.2% and one hundred and fifty removes 36.5%. Of the 31,760 videos in this site’s corpus, 14 have “mutual fund” in the title at a median of 72,156 views and 30 have “index fund” at a median of 74,230. The figures are in research/series-measurements.json and research/corpus-coverage.json.

A 72-bar window of the shared price history, cut short at the decision bar. The headline on the chart reads: It beat the index for three years. Skill?
It beat the index for three years. Skill? Illustrative chart - not real market data.

The 36.5% figure contains no return assumption at all — it is the charge compounding against itself, so the real cost on a growing pot is larger. Before comparing any two funds, write down the fee difference and multiply it by roughly twenty-four to get the share of the final amount at stake. It converts a number too small to feel into one that decides the outcome, which is exactly what the annual presentation is bad at.

Index funds is the low-cost alternative and the fee arithmetic in full. ETF investing is the exchange-traded wrapper. And passive income covers what these holdings are usually bought for.

What I actually do

I have no objection to paying for skill. What I object to is paying for it without a way to tell whether I got it, and three good years is not a way. The fee is certain and the outperformance is not, which is the whole comparison in one sentence.

— Michael Whitman

This page is educational, not financial advice. Test every idea on your own charts before risking money.