Are Fund Expenses Eating Your Lunch?

A new method of calculation shows they may be

How much are you paying mutual-fund companies to manage and operate your funds? Industrywide, the average expense ratio--that's expenses as a percentage of assets--is 1.4% a year for domestic equity funds. That may not seem like much, and as often as fund critics and the media complain about it, the figure has been fairly static for years.

What if expenses were reported as a percentage of returns? That puts mutual-fund overhead in a whole new light--and it's not pretty. With poor returns and high fees, expenses for Alliance Capital Management funds ended up consuming nearly 16% a year of the gross returns over the past five years. Even at Vanguard Group, the lowest-cost fund outfit, expenses came to 4.2%. These are among the findings of a recent study by Kanon Bloch Carré, a Boston-based investment consulting firm.

The study focused on the 20 largest fund families, and looked just at diversified U.S. equity funds. That got rid of the higher-cost sector and foreign funds. Since results are reported net after expenses, Kanon added expenses to returns to come up with a gross annualized return. Then, Kanon divided the expense ratio by the gross return. That yields the percentage of returns eaten up by management fees and operational costs (table).

The study has its critics. Not all families have the same mix of funds, and the returns can vary depending on which investment style is in favor. "Alliance Capital traditionally has been a growth-stock-oriented fund family," says John Meyers, an Alliance Capital spokesperson. "But growth investing has been out of favor for some time now." Meyers thinks the study is biased toward value-oriented families, which have fared better in the bear market.

But Kanon's study covers the five years ended Mar. 31. That interval included both bull and bear markets, and periods in which growth and value both led and lagged. "When I ran a similar study at the end of 1999, investors were paying only between 2% to 5% of profits at most fund families," says William Dougherty, Kanon's president. "There was too much bull-market noise in the results. But this year's study covers both the good and the bad--a full market cycle." Moreover, growth-oriented Janus Funds scored well despite the downturn because of lower fees and high bull-market returns.

The study reinforces the importance of investing in low-cost funds. Even when times are good, fees are significant. "A $10,000 investment in a fund with a 2% expense ratio that delivers a 10% gross annualized return will be worth $1 million after 40 years if you don't deduct its fees," says Brian Mattes, a Vanguard spokesman. "After deducting them, your investment's worth only $500,000."

Moreover, managers of high-cost funds may take on more risk than low-cost fund managers do because they need a higher return to beat their benchmarks after deducting their fees. The lowest-cost fund families--Vanguard, American Funds, and Fidelity Investments--ranked 6th, 1st, and 4th out of the 20 fund families, based on Kanon's risk-adjusted returns. The three with the worst such returns--American Express, Alliance, and Dreyfus--all had significantly higher expense ratios.

This data would be even more useful if it were calculated for individual funds, so shareholders could better assess their performance. If you have the returns and the expense ratio, you can crunch the numbers for your particular funds with just a pencil and paper. You might find that the fund company is getting paid better than you are--and you're the one whose money is at risk.

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