A mutual fund’s fees and expenses may be more important than an investor might realize. Ads, rankings and ratings will often emphasize how well a fund has performed in the past. But according to the Securities and Exchange Commission (SEC), studies show that the future often is different. Fees and expenses can be a reliable predictor of mutual fund performance.

When considering a mutual fund, one of the most important numbers is the expense ratio, which tells you how much the fund costs. The ratio shows how much of the fund’s assets are paid to the portfolio manager and for other operating expenses. Typically, a fund pays an average of 1.5 percent of assets annually.

Three things typically figure into this ratio. The investment advisory fee pays the managers of the fund, which accounts for .50 to 1 percent. Then, administrative costs cover services such as record keeping, mailing and maintaining a customer service line, which can range from .20 to .40 percent. And often a fund will charge a 12b-1 distribution fee, which covers marketing, advertising and distribution services. This ranges from .25 percent to 1 percent of assets.

The upper range of these fees shows how high an expense ratio can be. And even though the fee seems to be just a few percentage points, it is charged in down years, when it can represent a significant slice of the return. Also, over time, the fee can cut the ultimate return by nearly 50 percent, according to one analysis. With an initial $10,000 invested after 30 years of 10 percent returns (a bit optimistic, perhaps), the fund has made $174,494, but with a 2.5 percent expense ratio, it has lost $86,944, according to an analysis by Moolanomy.com.

But even that isn’t the bottom line. There are still transaction fees incurred by the buying and selling of assets in the fund that go unreported, and that can double or triple the cost, according to Richard Kopcke of the Center for Retirement Research at Boston College.

Of the 100 largest stock funds held in defined contribution plans as of December 2007, trading costs averaged from 0.11 percent of assets annually in the quintile with the lowest costs to 1.99 percent of assets in the quintile with the highest costs, with a median of 0.66 percent, Kopcke found. But it is difficult for average investors to determine this percentage, he said.

The SEC has not been able to develop ways to report this percentage in the same way an expense ratio is reported, partly because fund managers say the number is too difficult to determine. One way to get an indication of the percentage is the fund’s turnover. The percentage of turnover shows at what rate stocks in the fund have been replaced. A high turnover rate would mean more fees.

The SEC last year required fund managers to disclose one year of turnover at the front of a prospectus in addition to the already required five years of turnover disclosed in the financial highlights section, according to a March 1 Wall Street Journal article. Turnover of more than 100 percent can indicate trading costs may be high, the Journal reported.

                        

Derivatives protect people from a change in prices of an underlying asset. They began, generally speaking, as a hedge against changes in commodities prices. So, if you are a corn farmer and want to be able to plan on how much you will receive for your crop, you can agree on the price with a miller. The farmer is in a sense betting that the price will be higher or at least the same as the rest of the market at harvest time, and the miller is betting that the price will be lower or at least the same – and the miller is ensured of a supply of corn. The result is stability for both parties. The agreement is derived from the underlying asset of corn. That is the essence of a derivative.

Derivatives also hedge against price changes in other financial instruments and can become far more complicated or “exotic.” An institution can buy a credit default swap (CDS), for example. Institution No. 1 would pay institution No. 2 to ensure that the value of an asset does not fall under a certain level. If the value does drop, then No. 2 would pay No. 1. When the value of real estate plummeted in 2007 and 2008, many No. 1 institutions were banging on No. 2 institutions’ doors to get paid. This was one of the factors leading to the economic collapse, when the overall value of the CDS market dropped from $62.2 trillion at the end of 2007 to $38.6 trillion at the end of 2008, according to the International Swaps and Derivatives Association.

Another factor was collateralized debt obligations (CDOs). These are packages of debts such as bonds or mortgage-backed securities. The idea is to reduce risk by spreading it around. But some in finance, such as Warren Buffett, said that they instead spread risky investments to more institutions. So when the underlying, or derived, asset plummeted, the rug was pulled out from under everyone.

Although some, like Buffett, had sounded the alarm on derivatives, many people were surprised by the enormous impact the instruments had on the financial sector in the collapse of September 2008. Regulators were also surprised, because derivatives are often unregulated because they are essentially an agreement exchanged between parties but amount to a $400 trillion market traded over the counter (OTC).

Financial reformers want to shed more light on the market, but on April 21, a Senate committee went even further than that and approved tough standards that would force banks to get rid of their swaps trading operations. That rule might not make it to the final financial reform package, but it is certain that the eventual law will clamp down on derivatives in some way.

                        

For the past 10 years, gold has been surpassing expectations. It had dropped to $272 an ounce in 2000, and, at the time, few thought the price would rise dramatically. But over the past decade the price kept rising – breaking records – until it hit a high of $1,226 in December 2009. With each new record, many observers predicted that the price could not possibly go much higher and that the bubble would burst. As of this writing, the price has dropped to $1,092, with many analysts saying that the bubble has finally burst. But that has been said many times in the past decade, only to be followed by another rally.

Back in 2000, those who predicted higher gold prices were envisioning a worsening economy, which usually drives up the value of gold. It is the standard investment that many turn to for security in uncertain times.

Quite often the price performance is the inverse of the stock market’s, which does better in a stable environment. Some say now that the economy appears to be steadying, gold prices should stabilize or drop. In fact, many financial advisors caution against jumping into the precious metals market, fearing a plummet. Even some of those who previously encouraged precious metals investing are backing off these days.

“It was great to get in about three or four years ago, but now you have to be much more cautious,” Cary Carbonaro, a financial planner with Stonegate Wealth Management of Clermont, Fla., told the Orlando Sentinel. “It has had a huge run-up, but it is a cyclical thing.”

Even George Soros said, during the World Economic Forum in Davos earlier this year, “The ultimate asset bubble is gold,” but then, according to reports, doubled his own investment in gold a month later. That could be because he foresees an increase in inflation, which also drives up the value of gold.

Those who want to jump on the golden bandwagon are advised to be cautious in taking that leap. Even the most enthusiastic advisors still say investors should put only a small percentage into precious metals – 5 to 10 percent of their total investment money at most. Also, most advise their clients to invest in a fund rather than buy the metal itself, mostly for security reasons. After all, what’s the use of an insecure investment meant to bring security in an insecure time?

                        

With individual stocks, investors are obviously tied to the fate of a few companies. Also, some individual investors have found they don’t want to be playing the market, trying to time increases and decreases and earning more gray hair than money during prolonged downturns.

Some might turn to mutual funds, which would pool huge sums of money and invest it across many industries and types of investments. One fund can include stocks and bonds. Another type is a subcategory fund that might only have stocks and maybe even only focus on a particular industry. Individuals have a vast universe of funds to choose from to match their risk tolerance and investment preferences.

Some people might like the idea of the mutual fund but not the lack of control. They don’t want to just set it and forget it.

For them, exchange-traded funds offer an acceptable hybrid. ETFs can be thought of as a mutual fund that trades like a stock. Like an index mutual fund, an ETF represents a basket of stocks that reflect an index such as the S&P 500. But it can be traded on a stock exchange, just like a company. ETFs combine the benefits of a mutual fund’s investment diversification and low operating costs with the trading flexibility of individual stocks. Investors can short-sell ETFs, buy them on margin and purchase only one share, just like a stock.

ETFs have grown in popularity very quickly since they were introduced in the early 1990s. The first successful one was an SPDR fund, managed by State Street Global Advisors. The acronym came from the first fund, the Standard & Poor’s Depositary Receipts (SPY), which is also reportedly the biggest ETF in the United States. State Street now manages many SPDRs.

Now hundreds of ETFs are trading on the market, tracking a wide variety of sector-specific, country-specific and broad-market indexes. Some investors also like ETFs for their transparency; they are required to reveal their holdings on a daily basis, unlike mutual funds, which only do so periodically.

Whatever the reasons, it is clear that people like them, because ETFs have grown tremendously during the recession. ETFs now have more than $1 trillion invested in them, according to a BlackRock report in January. The assets under ETFs’ management worldwide grew by 45.2 percent in 2009 alone. That momentum does not appear to be slowing down this year.

                        

For example, an investor who puts $50,000 in five different bonds with a face value of $10,000 each has set up a bond ladder with five rungs. Each rung has a different maturity date. The first rung of bonds matures in one year, the second rung matures in two years, the third rung in three years, the fourth in four years and the fifth in five years. In effect, each rung of bonds reaches maturity at an interval of one year.

The distance between the rungs – that is, the interval of bond maturities – can be set anywhere from every few months to a few years. Bonds, however, are long-term investment vehicles that earn higher yields with time. Making the distance between the rungs longer typically results in better yields. The trade-off is that this exposes the investor to reinvestment risks and lack of access to the funds. Making the distance between the rungs shorter reduces the average return.

Financial experts use bond ladders to generate consistent returns and low risk, and to adjust cash flows according to the investor’s financial objectives. For example, the bond ladder can be set up to function as a source of income during retirement..

By staggering the maturity dates the investor also avoids being locked into one particular bond for a long duration, unprotected from bull and bear bond markets. If the investor poured the full $50,000 into one single bond with a yield of 5 percent for a term of 10 years, he or she wouldn’t be able to capitalize on increasing or decreasing interest rates. The bond ladder approach smoothes out market fluctuations because bonds mature at regular intervals.

A bond ladder also protects the bond portfolio from call risk. Call risk is when a bond issuer takes advantage of the callable bond feature and redeems the issue prior to maturity because of the high rate being paid on the bond. In a bond ladder, there is little chance that all bonds in one portfolio will be called at once because the maturities are staggered.

The bond ladder approach can be used for various fixed-income investment vehicles, including debentures, government bonds, municipal bonds, Treasury bills and certificates of deposit. The “ideal” bond for this strategy depends on the investment objectives and the investor’s preference.