Mutual Funds: Why Fees Still Defy Gravity

Investors aren't alone in seeking answers. Now regulators want to know, too

There's no doubt that the heat is on mutual-fund companies to lower their expenses. Fueled by competition and prompted by regulators, a number of firms have reduced or waived fees in the past 12 months. But that doesn't mean the ordinary investor is going to be much better off.

The annual fees charged by fund companies have barely budged, even though assets have increased elevenfold since 1989, to more than $6 trillion. Although fund fees are down modestly from 2003, retail investors are actually paying more today than they did 15 years ago: a dollar-weighted total expense ratio of 0.96% of assets, vs. 0.94%, according to researcher Morningstar Inc.

In theory, as fund assets zoom up, the costs of running a portfolio shouldn't rise nearly as much, so fees should fall. But that just isn't happening consistently. Says Russel Kinnel, director of mutual-fund research at Morningstar: "The mutual-fund business hasn't done a good job of delivering economies of scale."

Fees might not have mattered so much at the height of the bull market. But in today's lower-returns environment, investors can't afford to ignore costs. "Investors need to pay greater attention to the drags on performance," says Tom Roseen, an analyst with Lipper. He figures sales charges, expenses, and taxes together eat up between 40% and 60% of a fund's gross returns.

Fortunately, thanks to increasing competition, investors have a better shot at keeping costs down. American Funds Group cut its advisory fees by 5% late last year and another 5% this year. In Growth Fund of America, that means annual savings of 29 cents for every $1,000 invested. The Vanguard Group will soon make it easier for investors to qualify for its cheapest class of retail shares, which have expenses of just 0.09% for the Vanguard 500 Index Fund.


Still, investors shouldn't expect to see drastic markdowns in total expenses industrywide. It's more likely that the cuts will be just a couple of basis points, or hundredths of a percent, overall. Even though the majority of fund companies and fund boards are actively engaged in discussions about fee cuts, a number of factors are keeping a floor under annual expenses paid by investors -- despite the billions pouring into funds that should be creating signficant economies of scale.

For one, the middlemen -- the brokers and the fund supermarkets -- that sell the funds take a big chunk of the money. The typical 12(b)-1 fee, or marketing fee, on a fund that has an up-front sales charge is 0.25% of assets. At the same time, investors are buying more specialized funds that charge heftier fees like small-cap and foreign funds. These funds are often smaller, and their research and personnel costs can run higher as a percentage of assets. Despite the pressure on fund companies to lower their management fees, which make up a big part of the total expenses, not everyone is getting the message.

Around 80% of individual investors buy their funds through an intermediary such as a fee-only financial planner or a broker. Historically, brokers were paid a one-time commission at the time of purchase. But over the years, fund companies have become less reliant on up-front sales charges to compensate advisers.

These loads, as they're called, have come down from a high of 8.75% to around 5%. Instead, brokers are taking a piece of the annual expenses, generally from 12(b)-1 fees. Typically, shares of a fund that come with a full up-front commission tack on 25 basis points to their expense ratios to pay for marketing costs and ongoing advice from brokers. Other classes of shares with reduced or no sales charges jack up 12(b)-1 fees even more, typically by 50 to 100 basis points. "The majority of investors want advice,"says mutual-fund consultant Geoffrey H. Bobroff of East Greenwich, R.I. "They have the choice to either pay it in the framework of the fund or they pay it as a separate fee [to an adviser]."

Although they have long been standard in the industry, 12(b)-1 fees and other payments to brokers are currently being scrutinized by the Securities & Exchange Commission. However, the agency is still scratching its head over whether it should do something about them.

At the same time, investors have more options than ever. There are at least 6,000 mutual funds available in hundreds of flavors. But the more exotic the fund, the higher the price tag tends to be. For example, Fidelity Magellan (FMAGX ) Fund, a large-cap domestic equity portfolio, has an expense ratio of 0.70%. Fidelity Small Cap Stock Fund (FSLCX ), which invests mainly in smaller-sized U.S. companies, costs 1.08% a year. In part, that's because smaller stocks are less covered by Wall Street analysts and require more legwork to research.

Many of the funds Fidelity Investments and other companies have added in recent years are in expensive categories such as small caps and international stocks. That's one reason why the Boston firm's dollar-weighted expense ratio has dropped only modestly, from 0.87% to 0.80%, according to Morningstar, even though the firm has taken in more than $550 billion in assets over the past 15 years. If you exclude newer funds, Fidelity says it's expense ratio fell by 20 basis points.


Such drops at Fidelity and other companies, including Vanguard, American Funds, and T. Rowe Price Group (TROW ), are typically the result of discounts on management fees that are triggered as assets grow. More and more companies are thinking about introducing similar fee schedules or revamping current ones. But that doesn't mean the advisory fees on all funds will fall. Companies are adding new services, such as interactive Web sites, and the costs to comply with the new regulations are hefty. Some fund companies may always be more interested in lining their pockets than doing right by shareholders.

Still, in this competitive environment there's no reason to buy a fund from a company that isn't making an effort to lower its costs. The average investor may not get a good deal. But that doesn't mean a savvy one can't.

By Adrienne Carter in Chicago, with Aaron Pressman in Boston

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