Fees in a Mutual Fund Prospectus: Three Ways A Prospectus Deceives

(part 3 of 3)

Last time we looked at the list of fees within the “Fees and Expenses” section of a prospectus. There’s another misleading chart in this part of the prospectus. It’s the ten year fee table that purports to show the expenses on a $10,000 investment. You’ll find it in all mutual fund prospectuses. This is what happens in a chart called “Expenses on a $10,000 Investment.”

It’s easy to overlook the impact of fees when they’re divorced from earnings.

This chart shows fees taken out at the end of 1, 3, 5, and 10 year periods. It is required by the SEC. Click here to see the SEC’s tips for reading reading a prospectus.

Here’s an example of this chart based on 5% earnings and a 1% fee:

“Expenses on a $10,000 investment”* (See how amounts are computed below.)

1 year    3 years    5 years    10 years
$105     $344        $625       $1,557

A compounded 1% fee on $10,000 comes to a little over $100. That seems so little compared to $10,000. But that isn’t anywhere close to the actual amount you will pay each year.

Your “actual” fee deduction is the difference between the amount your money makes and how much is taken out for fees during that same time period.

In the SEC ten year fee table example, that’s (5% of $10,000) or $500 minus (1% of $10,000) or $100. That’s $500 minus $100 for the first year.

$100 divided by $500 is 20%, not 1% in fees on your earnings each year.

Your compounded earnings go up by over 5% each year, but you are losing 20% of that amount each year because the annual fees you’re charged are on your total investment. Each year you’ll lose one-fifth of your compounded earnings!

Here’s another way to look at this. Over a period of ten years, assuming your investment earns zero, you’ll lose1% per year in fees from your initial investment of $10,000. That’a 10% or $1,000! Over fifty years, you’ll lose 50 percent of your initial investment to fees. That’s $5,000!

You lose a such large chunk of your investment over the long term because the 1% fee is charged over and over again every year against the same total investment you made at the beginning, i.e., the $10,000.

In order to make anything at all from your investment, your real earnings must make up for the 20% fee that’s deducted annually from the total of your earnings and the compound interest on those earnings. This is why the chart below shows a loss of so much at the end of a period of 51 years.

Thanks to the magic of compounding and the sleight of hand that takes fee deductions out of the entire mutual fund so that they’re invisible to you, after 51 years you’ll pay fees equal to 40% of your initial investment and its total earnings.  After  51 years your $10,000 investment would earn over $120,000. But when a 1% fee is taken out each year, your return will only be $72,000, or 60% of what your money actually earned. You’ll pay over $48,000 in fees at 1%.

Looking at the ten year fee table in a prospectus you’d never guess this!

Why doesn’t the ten year fee table in a prospectus show this consequence of paying 1% in fees? Because the SEC-mandated fee chart is not intended to show you the actual amounts fees will cost you. It is intended merely to let you compare certain types of fees for one mutual fund with the same types of fees at another mutual fund.

What should be in a prospectus?

The SEC’s required fee chart is disingenuous. A prospectus should show the actual cost of fees charged on mutual fund earnings compounded over time.

The difference in expectations about fees versus their reality is outrageous! Many mutual fund investors wind up with a vague feeling after years of investing that something wasn’t right. They didn’t get what they thought they were going to get. Now you know why.

I think prospectuses should be required to include a chart showing both fees and earnings, like the one below. And I feel 1% is way too much! Wouldn’t you agree?

CHART:  Mutual Fund Fees and Earnings over 51 Years at 5%

* To see the the actual cost of a 1% fee on $10,000 at 5% over a ten year period, take the amount over $10,000 in the “no fee” column and subtract the amount over $10,000 in the 1% fee column for that year

For example, for Year 1
$500 – $395 = $105.

For Year 5
$2,762 – $2,137 = $625.

**For fun, compare the above chart to the chart for 8% earnings in my previous post, “Financial Advisors’ Commissions and Fees.” (Be sure to add a zero at the end of each amount in that chart. It’s based on $1,000 instead of $10,000.) You’ll be amazed at how a 3% increase in earnings affects the total amount of fees you’ll pay!  At 8% interest after 50 years, your $10,000 would earn $506,537, but you’d lose $203,198 in fees at 1%.

Copyright © 2010 Nancy K. Humphreys  All rights reserved. You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://brucenomics.com/.