While the bull market was roaring along, mutual fund shareholders could afford to be the investing world’s equivalent of $100 tippers.
When the average equity fund was returning 13.8 percent a year, as it did between 1988 and 1993, how many really cared whether they paid their fund an annual fee of 0.5 percent or 2.5 percent-or even more-to defray administrative costs?
Well, even if you didn’t mind before, you should now. Last year’s grim markets resoundingly signaled the end of easy money. If, as many forecasters anticipate, stocks and bonds settle back to their respective long-term average gains of 7 and 2 percentage points above the rate of inflation over the next few years, every point you pay in annual fund fees will consume between 14 and 50 percent of your real return.
Unless you’re content to let that portion of your potential profit slide into your fund manager’s pocket, you will need to become a much savvier customer. Next time you hear from a fund company, keep the following points in mind:
– Annual fees sap your long-term returns even more than one-time sales charges. Because they are often levied in a lump sum of 4 percent or so when you invest, upfront sales loads are the most obvious of the costs fund shareholders bear. But they don’t make fund companies rich. In fact, most fund companies keep very little of the load: Virtually all the money is divided between the broker who sold the fund and the broker’s firm.
Far more important, both to fund companies and to long-term investors, are the seemingly minor slices deducted from your holdings year after year. They include management and shareholder servicing fees.
On the average domestic-stock fund, these total 1.36 percent of assets (a figure known as the expense ratio). The average taxable bond fund’s expense ratio is about 0.9 percent; for tax-exempt fund’s, it’s about 0.8; and for money-market funds, about 0.6.
Because of compounding, the penalty imposed by a higher annual expense ratio builds. In theory, a portfolio that returns 7 percent before levying expenses of 1 percent a year will outgain a hypothetical twin with a 2 percent expense ratio by 4.9 percent after five years. The performance gap will grow to 9.9 percent by year 10 and to 20.9 percent by year 20.
– Fund shareholders overpay. Bond fund investors pay an average of 0.65 percent in fees for investment management, according to the Boston financial research firm Dalbar Inc. (Remember that the expense ratios cited above for bond funds include all annual expenses, not just those for investment management.)
That’s more than twice the 0.3 percent that pension funds and other institutions pay for fixed-income portfolio management, according to Greenwich Associates, a research firm that tracks pension fund investments.
Fund executives counter that retail investors get more services than institutions. “Fund management fees typically include fees not only for investment advice but for a host of administrative services,” says Matt Fink, president of the Investment Company Institute, the fund industry’s trade group.
Among others, he named daily pricing, fund literature and state registration fees. But other experts deny that such services account for the whole difference.
– Expense ratios still keep going up. It may at first seem normal that fund fees should get higher over time. After all, inflation drives up most consumer prices. Remember, however, that funds assess fees as a percentage of assets. So had they not changed expense ratios at all, fund managers as a whole would have received a 535 percent raise in the past decade simply from the fund industry’s asset growth.
Some fund executives reply that they’ve had to raise fees to improve services, such as automated telephone lines and shareholder newsletters. Such arguments would be more persuasive if fund assets had not ballooned from $49 billion to $1.6 trillion over the period.
– You’re helping to pay the fund’s marketing costs. Competition from no-loads helped shrink sales load over the past decade, one of the few fund arenas in which market forces succeed in lowering shareholders’ prices.
But while front-end loads have fallen, the benefit to shareholders has been eroded by the rise of 12b-1 fees, an annual distribution charge that can range from 0.15 percent to 1 percent of assets. Before the SEC approved rule 12b-1 a decade and a half ago, distribution costs were considered the fund sponsor’s responsibility.
– Fund companies nick you for services besides investment advice. Portfolio management isn’t the only service that fund investors pay for. On a $10,000 investment, you spend an average of about $19 a year on the fund’s transfer agent, which is the outfit that handles investor questions, tracks shareholders’ accounts, mails dividend checks and so on. Another $8.30 goes to the fund’s custodian bank, which holds the fund’s securities for safekeeping.
Until recently, the transfer agent and custodian businesses were dominated by specialized firms, but increasingly fund management companies are performing these activities themselves-and pocketing the fees. A management company with its own shareholder servicing subsidiary has little incentive to strike a good deal for shareholders.
– What investors and regulators can do to control fund expenses. While the SEC should not get into the business of telling mutual funds how much they can charge, the commission should require funds to be more forthcoming about the cost of investing. It has already taken one step:
Fund companies that ask for a fee increase now have to reveal in the fund’s proxy statement how much the higher expenses will cost the average investor over a one-, three-, five- and 10-year period.
For fund shareholders, the key to managing cost is vigilance and education. Before you invest, acquaint yourself with all the fund’s expenses, which are summarized in a table on the first few pages of every prospectus.
Avoid funds with high expenses, regardless of how strong their recent performance may be. That means swearing off stock funds with average annual fees of 1.50 percent or more, taxable bond funds with costs greater than 1 percent and tax-exempt funds with charges exceeding 0.75 percent. (Because international funds face higher administrative costs, the hurdle can be 2 percent.)
Read the proxy carefully enough to determine if the fund group is asking for higher fees. If so, the rest of your job is simple. Just say no.
