A Suze Orman exclusive

Alrighty, now that we’ve taken care of everyone with a super-short mutual fund attention span, I want to dive into a bit more detail on how to analyze mutual funds. Don’t worry, this is not really that hard, nor is it terribly time-consuming. It all boils down to four simple factors...

• Expense Ratio
• Loads
• Portfolio Focus
• Track Record

Oh sure, if you want to dive deeper, there is a ton of analysis you could do—but I truly believe if you nail these four fund fundamentals you are going to be just fine.

Expense Ratios
Every fund charges an annual fee to cover its operation and management fees. The fee is subtracted from the fund’s gross return before you see the net return that your account earned, so it never shows up in any statement as a cost you paid. But precisely because it isn’t easy to “see,” it’s crucial to know exactly what you are paying every year to be invested in that fund.

The average expense ratio for a managed stock fund is about 1.5 percent. But remember that many index funds charge less than 0.20 percent. That difference in the expense ratio is one of the main reasons that the average managed fund has a tough time beating index funds over the long term. Just think about it for a sec. Two funds each post a 10 percent return, but one fund has 1.5 percentage points shaved off to pay the expense ratio, while the other fund has just 0.20 shaved off. That reduces their net returns to 8.5 percent and 9.8 percent, respectively. That’s a huge difference. A $10,000 investment that compounds at 8.5 percent for 20 years will grow to about $51,000. If the rate of return is 9.8 percent, the investment will grow to nearly $65,000. I hope that got your attention; the moral, obviously, is that expense ratios are a huge deal!

You can check out a fund’s expense ratio by entering the fund’s five-letter ticker symbol in the Yahoo! Finance Quote Box, and then click on the Profile link on the left side of the page. The expense ratio information is on the right side of the page underneath the header Fees & Expenses. What’s really great is that the Yahoo data tells you how each fund’s expense ratio compares to similar funds.

Loads
In addition to the annual expense ratio that every fund charges, there are also some funds that charge additional sales fees. Funds that hit you up with a sales commission are called “load” funds. Funds without the sales fee are called “no-loads.”

I can’t stand load funds. The load is used to pay the broker or adviser who sells you the fund. But, come on, ask yourself whether the broker who sold you the fund has anything very meaningful to do with the performance of the fund. The answer to that question is no. It is just like a car sales person. Does the person who sold you your car have anything to do with its performance? Nope. It is the manufacturer and the mechanic who determine how well your car operates. The mechanic of a mutual fund is the portfolio manager, not the sales person. Every mutual fund has a portfolio manager whether they are a no-load or a load fund, and these portfolio managers are paid from the expense ratio that we talked about above. My point is that paying a load in no way affects the performance of a fund.

There are two types of load funds: a “front-end” load fund and a “deferred-sales” load fund. You can easily spot both by their names. A front-end load fund will have an “A” on the end of its name. This type of load fund charges you a commission right when you invest. If the fund has a 5 percent load, and you invest $10,000, you will only really have $9,500 put into your account, since 5 percent ($500) went to pay the broker/advisor. A telling way to look at this is that if you buy an A share fund with a 5 percent load, it has to go up about 5.25 percent just for you to break even ($10,000). But if you invest $10,000 in a no-load, all $10,000 goes to work for you, so a 5 percent gain means you will have $10,500.

The other type of load fund is even worse. They are known as B share funds (yep, there’s a B at the end of their name). The sales spiel on B share funds usually tries to sweet talk you by claiming that if you just stay invested for a set period—typically five years—there will be no sales commission. This is incredibly deceptive. Let me explain.

When the broker sells you a B share fund, he is not doing it out of the goodness of his heart. Even though you don’t pay a commission right when you invest, the broker indeed gets paid a commission by the fund company. And you better believe the fund company is going to make sure you pay them back for this expense. How do they get their money back from you? Remember a few minutes ago I mentioned that all funds—both no-loads and loads—charge an ongoing annual fee called the expense ratio? Well, with a B share fund your expense ratio is going to be super-big to get back the money they advanced the broker.

In fact, the expense ratio on a B share fund can be double that charged on a front-end load fund. And that expense ratio is charged every year for as long as you are invested. It is insanity to pay 1.6 percent or close to 2 percent a year in an annual expense ratio (and that’s typical for these B share funds) when an index fund charges under 0.20 percent.

But wait, we’re not done with the bad news on B funds. The fund company also wants to make sure it’s protected if you sell the shares before it has time to recoup, through the higher expense ratio, the cost of the commission it paid to the broker. So that’s where the “deferred” sales commission comes into play. This is charged during what is called the “surrender period” for the fund, which again is typically five years. What this means is that if you sell your B shares at any time within the surrender period, you will be stuck paying a sales commission on the money you pull out. The commission is called a “surrender charge”; it can start at about 5 percent, then declines one percentage point each year until, after five or six years, you are finally released from its clutches.

You get how it works: either from the inflated expense ratio or the deferred sales charge, the fund company is going to get you to pay for that broker’s commission. So please, don’t fall for the crap that B shares won’t cost you anything. They are the costliest fund investment out there! Just look at any fund that has both A share and B share options. The A share fund, when you compare annual performances , will typically outperform the B share fund. Why? Because the expense ratio is subtracted from performance. So if each fund returns 10 percent gross, but the A share fund has an 0.80 expense ratio and the B share fund has a 1.6 percent expense ratio, the net return is 9.2 percent to the A share investor and just 8.4 percent to the B share investor.

And please realize that if you stay in a B share fund past the surrender period you are still going to be stuck paying the huge expense ratio every year—it never goes away.

The bottom line is that B share funds are just a deceptive way for brokers to try and snooker you into believing they are selling you a “no-load.” What a huge lie! In my opinion, whenever you see an A or B after a fund’s name I want you to just say N-O. A true no-load fund with a low expense ratio is always the better way to go.