If you pay a 1% AUM this is based on your total account value NOT just on the earnings. This may not seem to be a big deal to you if the stock market returns double digits, but what happens if the return is barely positive or even negative for the year? You would be giving your advisor most of your return from the investment or even paying them out of your capital. Your advisor may claim that his advice is helping you avoid getting hit as badly in the downturn, but the index fund will bounce back when the market does - you will never see the money you paid out to your advisor for the AUM fee.
Novine wrote:Let's say that all your money was invested at Vanguard paying no loads and much lower fees. If an EJ rep approached you today and asked you to move all your money to EJ, would you?
No, at least certainly not immediately. I would see what was offered and seek out more information, as I am doing right now. That direction is also biased since I would have to pay loads which have already been paid in this case.
The loads are a sunk cost. That should not be a consideration in whether you sell your fund and switch to VG. However, they are an important point with respect to the return you receive and whether or not you are getting value from you EJ relationship. If your rep says this fund earned x% vs an index earning y%, you need to understand the math.
A $1K investment in a VG index fund gives you a $1K starting investment. A $1K investment in an American fund with a 5.75% loan gives you a starting investment of $942.5. I guarantee any comparisons the EJ gives you is ignoring the load you paid and assumes that you start with the same amount in the account. (In addition, they may be doing a sleight of hand and ignoring the dividends you would have gotten from an index fund and just comparing your fund return to the raw index numbers).
This is similar for the capital gains tax issue. The EJ illustrations all assume that you reinvest dividends and capital gains. If this is a taxable account, then you are adding to your account by the amount of capital gains taxes each year (as someone else already posted). However, the real kicker comes after a period of good returns in the market. If OTHER investors decide to sell that fund then YOU can have huge capital gains distributions over which you have absolutely NO CONTROL. With an index fund, the only time you generate capital gains is when you actually sell your shares. This is a huge advantage in the long run, even if you may currently only be in the 15% marginal tax bracket. You might be interested in this article from Morningstar
But big capital gains distributions are frequently a delayed reaction to strong investment performance, showing up a year or more after funds have posted a series of strong gains. And many active funds continue to lose assets at the expense of index funds and ETFs, and that has been one of the key factors contributing to mutual fund capital gains distributions in the recent past. Such redemptions often force managers to sell appreciated securities in an effort to raise cash to pay off departing shareholders. Those distributions, in turn, are distributed over the fund's shrunken base of shareholders, effectively magnifying the size of the distribution for a fund's remaining investors. Manager changes, whereby a new manager upends a long-standing portfolio of highly appreciated securities in favor of his own portfolio, are another frequent catalyst for outsized capital gains distributions.
Indeed, many otherwise-solid mutual funds have proved quite tax-unfriendly over the years, making sizable capital gains distributions. And judging from still-sizable potential capital gains exposures--which reflect the percentage of a portfolio that consists of capital gains that haven't yet been distributed or taxed--there could be more distributions in the offing. For that reason, I've recommended that investors skip actively managed funds for their taxable accounts and opt for index products instead.
For each fund, Morningstar.com features a suite of data to help investors assess the tax efficiency of holdings. Tax-cost ratios show what percentage of returns that investors in the highest tax bracket would have ceded to taxes over various trailing periods. Potential capital gains exposure provides a view of the gains embedded in a given portfolio and, therefore, depict what gains could be distributed if the securities are sold to meet redemptions or in the wake of a management change.