Get cheap with mutual funds

NEW YORK (Money) -- Question: I have a question about how fees and expenses figure into the returns that are listed for all mutual funds. Are the returns you see after fees and expenses have been deducted? If that's the case, and I compare an index fund with low expenses to an actively managed fund that has higher fees but also a higher return, then I'd probably want to stay with the actively managed fund, right? - John Taylor

Answer: Well, you're largely correct on the fee issue, but I disagree about the conclusion you come to as a result of it. Let me explain.

The mutual fund returns that are listed in Money Magazine and that you'll see if use the Mutual Fund Screener tool on our Web site are net of all annual fund expenses. So let's say two funds with the exact portfolios each earn 9 percent before any expenses.

And let's further assume that one of those funds is an index fund that charges 0.25 percent of assets a year (many index funds actually charge less), while the other is an actively managed fund that charges 1.25 percent (many actively managed actually charge more). At the end of the year, you would end up with about an 8.75 percent return in the index fund and a 7.75 percent return in the actively managed fund.

So in order for the actively managed fund to post a higher net return than the index fund, it would have to earn roughly a percentage point more before expenses, or 10 percent instead of 9 percent, to equal the index fund's 8.75 percent return.

I've oversimplified a bit here. In reality, you won't have two funds that are precisely the same and even if they bought very similar stocks there would likely be other differences that could affect their net returns, such as how often they trade and thus incur transaction costs.

And I've also excluded any sales commissions you may pay when you buy into or cash out of a fund. These definitely do affect what you ultimately earn since less of the money you have to invest actually goes into the fund.

If, for example, you have $1,000 and pay a broker a 5.75 percent sales commission - or "load" as it's known in the fund world - only $942.50 of your $1,000 is actually invested. So the return you see in the fund listings is the return you earn on the $942.50 that went into the fund, not your original $1,000.

But the basic principle is valid: a fund with higher annual expenses must earn a higher annual return before expenses than a fund with slimmer expenses if it hopes to equal or exceed the net return of the lower-expense fund.

Now, is it possible that an actively managed fund might earn a high enough gross return so that even after deducting its higher annual expenses it would beat the index funds' net return?

Sure. There are plenty of instances of that. You sometimes have star fund managers like Bill Miller of Legg Mason Value Trust, who beat the Standard & Poor's 500 index 15 years in a row. And the legendary Peter Lynch handily whipped the S&P 500 index over the 13-year period he managed Fidelity's Magellan fund from the late 1970s to 1990.

And plenty of other managers manage to beat whatever index they're up against over shorter periods of time. But while it's easy in retrospect to find managers who manage to beat index funds over considerable periods, it's hard to tell in advance who those managers will be - I don't remember anyone predicting back in 1992 that Bill Miller was on his way to an incredible 15-year streak - and how many years they'll outrun the index.

And when you step back and look at the performance of actively managed funds vs. index funds over long periods of time, you'll find that index funds tend to beat the majority of actively managed funds. As John Bogle, the founder of the Vanguard fund group and father of the first retail index mutual fund, has pointed out in numerous books, articles and speeches over the years, the higher a fund's expenses, the worse it's likely to do over the long run.

The reason is simple: higher expenses are a drag that's difficult to overcome. It's like sending two teams of runners out to run a marathon but requiring one team to carry 25-pound backpacks. Which team do you think is likely to have the better average time? Maybe there will be a few superstars who can overcome the disadvantage of carrying extra weight, but they'll be the exceptions - and whether you can identify them at the starting line and say how long they'll manage to excel despite their baggage is questionable at best.

As I've said before, however, as big a fan as I am of index funds and even though I think most investors are better off keeping most of their investing stash in index funds, I don't think you would be undermining your financial future by investing a small portion of your money in actively managed funds.

To the extent you do that, though, I think you should still give the nod to funds that have a solid track record, a history of being shareholder friendly and that have below-average annual expenses - in short, funds like those you'll find in our MONEY 70 list of recommended mutual funds (which also, by the way, includes recommended index funds.

Bottom line: In investing, you can't control the size of the returns you earn because you can't control what the financial markets will deliver. But by being judicious in the funds you choose, you do have a good bit of influence over the size of the annual fees you pay and, therefore, the share of the market's return that will end up in your pocket.

The more you stick to index funds and other funds that charge modest expenses, the bigger the share of the market return you're likely to get.