Fund Fees and Your Bottom Line

It's easy for investors to overlook fund fees, because most don't know how much they're paying in hard dollars. Mutual fund firms don't send out bills for managing people's money. They just deduct their costs from a fund's returns, which are reported net of fees. Depending on a fund's expense ratio and the amount invested, fund shareholders could be saving tens of thousands of dollars over their investment lifetime by going with lower-cost options.

For example, imagine two funds that invest exactly the same way, but carry different expense ratios. Assume that both start with $10,000 and return 8% per year for 25 years. Fund A charges 0.5% per year in expenses ($50 for every $10,000 invested) and Fund B charges 2% per year ($200 per $10,000 invested). On the face of it, that $150 difference a year doesn't look like a whole lot. But at the end of 25 years, thanks to the benefits of compounding, Fund A would be worth $60,983 while Fund B would be worth just $42,919.

Fee Factors  
With that in mind, we looked at several factors to identify which funds have treated shareholders right in regard to costs. The first compares the fund's expense ratio to those of a group of funds investing in a similar asset class, and using similar distribution channels (i.e., we compared no-load funds with other no-load funds, A shares with other A shares, etc.). The groups are defined to include funds that should face comparable operation costs given their emphasis on a particular area of the market, such as domestic large-cap funds, sector funds, or foreign small/mid-cap funds. The focus on distribution channels is key. Different fee structures tend to skew category averages, making some funds appear reasonably priced mainly by virtue of how they are sold. By comparing similar structures, investors are able to get a more meaningful picture of where their funds stand.

Other factors look at more subjective trends that we see in a fund's expense ratio. Have costs gone down as assets have grown? Mutual funds have fixed costs--administrative, accounting, legal--that don't change significantly as a fund grows. We think funds that have seen explosive asset growth have an obligation to pass along economies of scale to shareholders. If a fund was fully capable of supporting those costs at a modest level of assets, why can't it lower costs significantly when assets grow? That's the question that funds such as  Calamos Growth need to answer. That fund charged a 1.5% expense ratio on $500 million in assets ($7.5 million in revenues) in 2001, yet fees have dipped to only 1.31% now that assets have surpassed $9 billion ($118 million in revenues).

A related problem is that some firms lock in a fixed percentage for their advisory services--known as the management fee--that is immune to the benefits of economies of scale. One notable example is  Clipper , which continues to levy a 1% management fee despite its sizable $6 billion asset base. On the other hand, Vanguard, negotiated a much lower fee from Alliance for subadvising its  Vanguard U.S. Growth Fund than Alliance charges for managing its own growth fund.

Another issue is large or closed funds that still charge 12b-1 fees. These fees were designed to serve as a marketing resource to grow assets so that fund shareholders could benefit from economies of scale. But they make little sense to current shareholders if the fund has become bloated, and are nonsensical if it is closed. Instead, more and more fund companies are using this levy to pay distributor servicing fees, which is contrary to their intended purpose. William Blair, Baron, and Bjurman, Barry are all examples of fund shops that continue to charge 12b-1 fees on closed funds.

Investors also need to be wary of funds with exotic fee structures. For instance, until a recent change,  Fidelity Advisor Destiny I and  Fidelity Advisor Destiny II could be purchased only through a contractual plan that included onerous up-front charges. (Both funds are now available with traditional, less-burdensome fee structures.) In these plans, investors commit to a program of investing at regular intervals for a minimum of 10 years. In many cases, the sales commissions amount to 50% in the first year of the plan, which puts shareholders in a serious hole before they start and can reduce the final value of their accounts--even if they stick with the plan.

Many of these problems fall to mutual fund boards of directors to address. Boards are responsible for negotiating fees on behalf of fund investors, yet many simply try to ensure that a fund's fees are near the average of a peer group--a peer group that is often narrowly defined, sometimes by a fund's management company. Although peer group comparisons are helpful, boards owe a duty to fund investors to go a step further and evaluate the reasonableness of the fees earned relative to the actual costs of running a fund and retaining management talent. Fund boards must also annually approve a fund's 12b-1 plan, and must find that it is beneficial to the fund and fund shareholders to do so.

Cost Controllers
The picture isn't entirely bleak, however. We have found numerous examples of practices that demonstrate a firm's resolve to control costs and pass savings along to shareholders. No discussion of fees would be complete without talking about Vanguard. Although it is known for its low-cost index offerings, this shop--as noted above--drives hard bargains with the sub-advisors on its actively managed funds. For example, funds such as  Vanguard Primecap charge an already low management fee that then declines as assets grow according to a predetermined schedule.

Performance fees are another way in which shareholders stand to benefit from a cost-conscious firm. Simply stated, performance fees are added (or subtracted) from the management fee levied on the fund for above (or below) average returns over a particular trailing time period. This sometimes results in higher fees for shareholders, but at least they know that those fees have been earned by solid performance. Conversely, shareholders earn a discount if a fund has underperformed. Shops noted for instituting performance fees are Fidelity, Bridgeway, and again, Vanguard. 

Not surprisingly, fund families that actively strive to keep costs down also tend to practice other shareholder-friendly traits. Firms such as Dodge & Cox, Longleaf Partners, and American Funds focus on investing for the long term, don't roll out trendy funds every couple of years, and takes strides to educate and keep their investors informed. Costs do matter and can be a telling sign of whether a fund is run in the interests of its shareholders.

* The Morningstar Fiduciary Grade for funds was renamed the Stewardship Grade for funds as of Feb. 7, 2005.