Is Your Mutual Fund a Rip-Off?

That's why I was surprised when he mentioned he was buying a pricey municipal-bond fund because of its high yield. (I immediately sent him my colleague Chris Davis' article on why there's more to investing than yield.) It got me thinking, though. If my own frugal father didn't recognize that he was about to buy an expensive fund, there are probably scores of other investors who are overpaying for their investments, simply because they don't have the proper context for what funds should cost. What's more, many investors might not be considering expenses at all when making investment decisions. A recent study showed that participants looking at different mutual fund advertisements tended to pay more attention to past performance than expense data. Below we'll take a look at how to better understand fund expenses so that you don't end up making a costly mistake.

Expense Ratio Crash Course
Loyal Morningstar readers might roll their eyes at yet another article preaching the merits of low-cost funds. But research has shown that funds with low expenses are the ones that tend to do better over time, leaving you with more money in your pocket.

So what exactly are you paying for when you buy a fund? A fund's expense ratio (found in the fund's prospectus and on a fund's Quote and Expenses tab on Morningstar.com) is calculated by dividing the fund's assets by its costs. It typically includes a management fee used to pay the people running the fund as well as administrative costs. Many funds also tack on 12b-1 fees, which go toward marketing or distribution costs, including paying commission to brokers who sell the fund. Note that the expense ratio doesn't include sales charges you might incur from buying the fund through a broker. These "loads" are listed on the Quote and Expenses tabs and should be considered an extra cost that you wouldn't pay when buying a no-load fund. (Read more about different loads and share classes here.) The expense ratio also ignores brokerage commissions and market-impact costs.  

A common question that arises when looking at Morningstar's expense data relates to the difference between a fund's annual report net expense ratio and prospectus net expense ratio. The annual report figure is the amount that investors actually paid in fees during the past fiscal year. The prospectus net expense ratio is a forecast of what investors will likely pay in the coming year based on the asset level listed in the fund's most recent prospectus. The two numbers won't always match, particularly if assets dramatically fluctuate. As we've pointed out, the prospectus net expense ratios for many funds, even low-cost leaders like Vanguard, have risen following a plunge in assets suffered during the financial crisis. On the other hand, you should expect to see a fund's expense ratio fall when the fund's assets grow. If not, it might mean the fund's board of directors isn't looking out for shareholders' best interests.

Bargain or Rip-Off?
Now that you know the basics, how do you gauge whether a fund is overpriced? To make sure you're comparing apples to apples, it's a good idea to assess a fund's expense ratio alongside other funds in that same category and share class. That's because more specialized offerings, like international-equity or sector funds, tend to have higher costs than straightforward government-bond funds. Small-cap funds can also be more expensive because they're not usually as big as funds that focus on large companies. Case in point: The median expense ratio for no-load small-cap funds is 1.20% compared with 0.95% for large-cap funds. (Morningstar analysts typically use the category median rather than a straight average because it prevents the number from being skewed by outliers, especially if the category has a small number of funds.) Funds with expenses that land in the cheapest 20% of the group are ideal, and those that fall above the category median are considered pricey. Check out the chart at the end of this article to see median expense ratios for different categories.

High expenses really eat away at your returns over the long run. Consider  PIMCO High Yield  , which has several share classes with different expense ratios. The institutional share class is the best deal. It costs a reasonable .52% and has generated an impressive 10-year annualized return of 5.9%. Compare that with the pricey C class of PIMCO High Yield , which has an expense ratio of 1.65%. Its annualized 10-year return is just 4.7%, significantly lower than the cheaper institutional share class. As this example shows, it clearly pays to be thrifty when shopping for funds.

Consult the chart below to see if you're paying too much for your funds. Most analyst reports also discuss whether a fund is a good deal. As a general rule of thumb, you shouldn't pay more than 0.75% for a bond fund and 1.0% for a core equity fund. (As I noted above, specialized funds like small-company or international funds may cost more.) And remember, just because you pick a low-cost fund doesn't mean it's low-quality. Our  Fund Analyst Picks are superb choices and are easy on the wallet.

Median Net Expense Ratios