(Editor’s Note: Following is a guest submission from Greg Retzloff, publisher of the well-regarded financial blog Workingman’s Dollar.)

By Greg Retzloff
www.workingmansdollar.com

Fund companies continue to post their total return figures in ads, carefully pulling together lists of funds that together compose what looks like a winning team. Morningstar ratings are often paraded along with these return figures as though Morningstar ratings have any real predictive power. Rarely mentioned in these stellar lists are sales fees, fund expenses, trading costs and taxes.

Professional investment advisors and informed individual investors know of the cumulative long-term effect of these costs on the real performance of mutual funds. But often both professional investment advisors and individual investors gladly ignore these costs as though they are just inconvenient reminders of the otherwise exceptional performance of the fund that they either currently own or want to buy.
 
Costs are important – very important! Even the best index funds from companies such as Vanguard and Dimensional Fund Advisors (DFA) have them, and actively managed funds will have added costs because of the expenses associated with active management and more frequent trading. 
 
It is unfortunate that investors are not provided with the cost-adjusted returns of funds in a single figure. These figures make a critical difference in the final investor returns. Neither the mutual fund industry nor the SEC require an actual “investor return” figure demonstrating the return an that investor would have received after all costs are deducted from total-return figures. So-called total-return figures do factor in management fees, but do not generally include trading or tax costs.

For example, the Dodge & Cox Stock fund (DODGX) posted a 10-year total annualized return of 5.51% according to Morningstar. This number factors in the expense ratio, but does not include the tax costs associated with the fund’s trading. The fund’s tax-adjusted return was just 4.04% for that period.

John Haslem wrote an interesting paper in 2006, “Assessing Mutual Fund Expenses and Transaction Costs.” In the paper he proposes an all-inclusive expense ratio that would include the following: regulatory expense ratio (management fees, 12b-1 fees, and other expenses), brokerage commissions, and implicit trading costs (generated by portfolio turnover). Together these would constitute a total expense ratio. This number would help an investor determine the true historical returns of a mutual fund. 

In the Meantime

The single total expense ratio suggested by Mr. Haslem doesn’t yet exist, but there is a good way to get a handle on the historical return of a mutual fund with a figure that does exist.   

The tax-adjusted return figure as provided by Morningstar is close to the actual total return figure we are looking for because it provides us with something resembling actual investor return over time. This figure indicates the total return of a fund less taxes and sales charges. You can find this number on Morninstar.com for a given fund based on three-, five- and ten-year time periods.

A fund that has been a consistent performer and kept costs and taxes low in the past is likely to be a good performer into the future. But, as always, past performance is no guarantee of future results.