Q. What is a good expense or normal range for expense ratios or fees for mutual funds?

---L. N., Houston, TX (by email)

  

A. Questions about "good" and "normal" in investing are interesting because what's "normal" for the industry may not be "good" for the investor. Let's start with the pragmatic view and examine the universe of funds.

When we do that we learn that the expense ratio of a fund is closely related to how it is sold. What some people call its "distribution channel."   Excluding the advisor channel, there are three main distribution channels for mutual funds:

•       Genuine no-load funds are the least expensive.

•       Front-end load funds, commonly known as "A" shares, are more expensive          and also charge a front-end commission.

•       And deferred load funds, which amortize a commission through a 12b-1          charge and are known as "B" shares, are most expensive.

While the average true no-load domestic equity fund costs 1.07 percent a year, "A" shares domestic equity funds cost an average of 1.52 percent and "B" shares cost an average of 2.06 percent.

The average true no-load international equity fund costs 1.36 percent a year but "A" shares in the same category average 1.89 percent and "B" shares average 2.48 percent.

Similarly, the average no-load taxable bond fund costs 0.71 percent while the average "A" shares taxable bond funds costs 1.13 percent and the average "B" shares fund costs 1.73 percent.

That's "normal" for the fund industry. What the averages don't tell you is that there are wide variations in costs in each distribution channel. Some no-load funds, for instance, have higher expenses than "A" shares. As I have pointed out many times, investors who need an advisor can be well served by investing in the American Funds family. Their American Balanced fund, for instance, has an expense ratio of 0.70 percent, well under the cost of the average no-load fund, and the 5.75 percent sales commission is reduced for large purchases. This fund (ticker: ABALX) has an exceptional performance record.

If a fund costs more than average for its distribution channel, the money will be coming out of your pocket. If it costs less, it will probably be reflected in somewhat better performance.

What you need to remember is that "normal" for the industry may not be "good" for you or anyone else. As I've pointed out many times, high expenses tend to mean lower returns.

If you screen out the thousands of small funds that have high expense ratios because they must spread their high fixed expenses over a small portfolio, average expenses drop pretty dramatically. Requiring that a fund have at least $500 million in assets, for instance, will often reduce the expense ratio by about 20 percent. Although there is a mystique about small and unknown funds, many have earned their obscurity.

A "good" expense ratio, in my mind, is one that is only a small premium to the expense ratio of a comparable index fund. A small premium would be, say, 50 basis points or 1/2 of 1 percent.

The Vanguard Balanced Index Fund, for instance, has an expense ratio of 0.22 percent. American Funds Balanced "A" shares, with an expense ratio of 0.70 percent and a maximum front-end load of 5.75 percent, has done better. Vanguard Wellington, a no-load fund with an expense ratio of 0.36 percent, has also done better. Ditto Dodge and Cox Balanced, a 0.53 percent expense ratio no load fund and Fidelity Puritan, expense ratio 0.63 percent. It's possible to beat an index and there are a handful of funds whose records justify the hope it can be done. But the operative word is "handful."

The greater the premium you pay for management, the greater the odds the managed fund will trail a simple index. This is particularly true for bond funds.

Needless to say, there are always exceptions to the rules and there are always "hot" funds that do exceptionally well in spite of their expenses. But over long periods of time, expenses are constant and talent is temporary.

Related Columns:

11/27/01: The Long Term Cost of Management Fees: Accumulation

12/18/01: The Lifetime Cost of Management Fees

11/03/02: Searching for Truly Long Term Winners and Indexing

03/25/03: Expense Ratios and Performance: Equity Funds