If you think fund expenses don't matter, better think again

Kiplinger's Personal Finance Magazine, March, 1998 by Robert Frick

How many times have we heard a TV pitchman holler, "We deal in volume and pass the savings along to you!" Now imagine the same guy saying, "We deal in volume and pass the savings along to ... us!" That may be the secret snicker of your mutual fund company. The question is, what are you going to do about it?

As the fund industry has swelled in the past decade from $770 billion in assets to more than $4 trillion, creating huge economies of scale, average expenses charged to stock-fund investors have actually risen, from 1.28% to 1.49%. The same trend applies to bond funds, whose average expense ratio is 1.05% today, versus 0.89% a decade ago. Scudder Development, an aggressive-growth fund with below-average returns, generates more than $10 million in fees each year from its 1.24% expense ratio. The gigantic Kaufmann fund grossed $116 million last year by paying itself 1.93% of its $6 billion in assets.

That higher expenses hurt fund returns is incontrovertible; by definition, expenses nip a percentage of your mutual fund assets each year. The higher the expense ratio, the harder it is to beat market indexes or category averages.

You're probably saying, I know that, I know that. But the extent to which returns dwindle because of higher expenses may surprise you because the expenses are deducted before the fund reports results to shareholders, We divided the 1,132 long-term-growth funds into two groups: those with expense ratios above the 1.48% average for the category and those with ratios below the norm. On average, those with lower expense ratios returned two percentage points a year more than funds with above-average expenses the past five years.

So if you dropped $10,000 into a higher-expense long-term-growth fund five years ago, you'd have about $1,500 less today than if you'd invested in a lower-expense fund. And if you were saving for a long-term goal -- say, retirement 25 years away -- you'd have 50% more at the end of that time with the lower-expense fund. (This assumes a 10% return for the high-expense fund, versus a 12% return for the low-expense fund.)

The results are the same in virtually every other fund category -- the low-expense funds return more, on average. than the high-expense funds. The exception is high-quality corporate-bond funds. In that category, the high-expense funds do better.

THE BIGGER, THE HIGHER

You'd think low-return, high-expense funds would shrivel up and die as smart investors left them for their cheaper competitors. But a study done by Jack Aber, professor of finance at Boston University, shows exactly the opposite is true: As fund size increases, fund expenses tend to rise rather than fall. The sad truth, Aber says, is that fund companies "aren't terribly motivated to compete on expenses because people don't seem to care," as long as the markets continue to do so well. Laments Don Phillips, president of Morningstar, the fund-research company: "As a whole, investors are pretty docile."

Small wonder, then, that the mutual fund business is now among the most profitable. Consider that for the 15 publicly owned fund companies, the average operating margin -- that is, income from the basic business before a host of extraneous costs are deducted -- is a robust 32%, says Bruce Brewington, an analyst for Putnam, Lovell & Thornton, a San Francisco investment bank that focuses on money-management firms. The health care and software industries have operating margins of just 26% and 25%, respectively.

From his vantage point dealing with money-management firms that serve individual investors or cater to multimillion-dollar clients, Brewington says that "mutual funds are not a cheap way" to manage investments. Large private accounts are managed for as little as 0.2% of assets per year. The handful of fund companies that focus on low costs -- given that they must pay for scores of customer-service reps and millions of mailings that advisers to large private clients do not -- can manage stock funds profitably for 0.5%.

WHO WILL SAVE YOU?

Fund expenses are broken into three categories. The largest is usually the management fee, which pays for the marketing and expertise needed to run the fund. Shareholders must approve an increase in this fee, and we have yet to hear of an instance when they refused. The rest goes for nuts and bolts -- such as trading securities, paying legal fees and providing services to shareholders. In addition, some funds assess 12b-1 fees, also to pay marketing costs, which include payments to brokers for selling shares.

Don't count on independent trustees at mutual fund companies to ratchet down expenses. John Bogle, chairman of the thrifty Vanguard Group of funds, says that compensation for directors at the ten highest-paying fund companies averages $150,000 per year, almost double the average at the ten best-paying Fortune 500 companies. That's a strong incentive not to rock the boat, Bogle says. Plus, he says, lowering expenses would have a cataclysmic effect on a fund company's profits and the value of the enterprise.