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Fat Fund Report

You Can Pay a Little… or a Lot: The Range of Mutual Fund Expenses

The table below divides the mutual fund categories studied into three major groups, equity funds, hybrid funds that mix equities and fixed income, and fixed income funds. One thing you can see immediately is that equity funds tend to cost more than hybrid funds and hybrid funds tend to cost more than fixed income funds. The reason for this is simple: fund management companies can get away with charging more for equity funds because they have traditionally offered the highest returns and because people attach the most hope to equity funds.

Some would argue that it is more expensive to manage an equity fund than a fixed income fund. Reality doesn’t support that claim because there are a lot of ways to manage both types of funds and there is no reason that fixed income funds are inherently less expensive.

The Distribution of Mutual Fund Expense Ratios, by Fund Category (Prospectus Net Expense Ratios)

Now let’s look at expense ratios from left to right, from the least expensive to the most expensive. If you know the net prospectus expense ratio for the funds you own you can use the table above to see whether your funds are high expense funds or low expense funds. You can tell whether your fund is in the least expensive quartile, the second lowest expense quartile, third quartile, or the most expensive quartile. You can also check to see if your funds are in the least expensive 10 percent or the most expensive 10 percent.

Some important questions:

1. Why do expenses matter?

Simple. Over long periods of time high expense funds tend to have lower returns than low expense funds. I have frequently found that the cost difference between expensive and inexpensive funds is about the difference between a fund performance in the top 25 percent and a fund performance in the bottom 25 percent. Think about what that can do to your retirement.

2. How do you find funds whose expenses are in the lowest quartile— funds that cost less than at least 75 percent of their competitors?

The easiest way to do this is to buy an index fund. And the exchange traded index funds are often the least expensive altogether. Using the broad category ETFs, for instance, is a pretty good way to be nearly certain of having expenses in the least expensive decile or 10 percent of category. While the least expensive decile of “large blend” funds begins at an expense ratio of 0.46 percent or less, the Vanguard 500 Index mutual fund (minimum purchase $3,000) has an expense ratio of only 0.18 percent. The ETF version is even less expensive, with the SPDR available at an expense ratio of only 0.09 percent. Of course, you have to pay a commission to buy and sell the fund, so the mutual fund will be less expensive for small investors.

Another way is to look for funds in the firms that are established low cost vendors. Vanguard is the obvious leader but there are a surprising number of firms that are reliably positioned in the lowest cost quartile. Fidelity, American Century, Janus and T. Rowe Price are strong candidates with their no-load funds. The American Funds group is a low cost vendor among funds that are distributed through brokerage firms.

3. How do you avoid funds whose expenses are in the highest cost quartile— funds that cost more than at least 75 percent of their competitors?

The easiest way to do this is not by firm but by distribution channel. If you buy “B” shares, the ones that substitute an annual charge for a front-end load commission, the 12b-1 fee is likely to put you in the most expensive funds group. It is the same with “C” shares, sometimes called the Poor Man’s Wrap Account. These funds charge a constant additional fee that goes to the broker or manager.

This isn’t limited to being a hapless individual investor. If you work for a small company the odds are you will have a relatively expensive set of choices in your 401(k) plan. Similarly, if you are a school teacher and have a 403(b) plan it is very likely that the products you will be offered will be expensive, insurance-based products such as variable annuities with average annual costs well over 2 percent.

In all of these cases, you have alternatives and choices. If your 401(k) or 403(b) plan has no employer match and costs 2 percent a year, you’d be far better off investing through a traditional Individual Retirement Account, IRA because you can do that with best quartile no-load funds.