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3 sure steps to bigger fund profits
Some things you can't control with mutual funds, but some you can. Cut costs, and higher returns take care of themselves.
By Timothy Middleton
After years of climbing inexorably, some mutual-fund expenses are beginning to fall. Not all of them, and not even a majority of them, but enough that vigilant fund investors can boost their profits.
It will take some digging and may even require a shift in portfolio strategy. An impression has risen that fee cuts are widespread, after abusive companies agreed to reduce them to settle charges following a fund-industry scandal that surfaced in 2003. The industry itself insists the trend in fees is broadly down.
Don't be fooled. Only a few firms are cutting fees, and then mostly on certain portfolios that were cheap to manage in the first place. "Over the years I have looked at fund fees, and it does not appear that they have dropped very much," says Edward O'Neal, a finance professor at the Babcock Graduate School of Business of Wake Forest University.
Indeed, on average they have gone up -- by nearly 5% in five years, according to Lipper. Money-management fees have been unchanged. The gouging occurs at the level of middleman costs, notably brokers' commissions.
3 ways to cut fees
Despite this, you can cut your own fees by taking these three steps:- Switch to indexing, where fee cuts have been huge.
- Choose big funds over small ones, because economies of scale are often passed along.
- If you do buy funds with sales charges, also known as loads, choose "A" shares over "B," because B shares are more expensive.
"It's very important to have low-fee funds," says William W. Cox, a financial adviser in Paducah, Ky. Fees subtract from performance penny for penny, and that's not their only bad attribute. If his fees are high, a fund manager has to take more risk to generate a decent net return. "If they're low, the fund manager can look more long term," Cox says.
The advent of exchange-traded funds has revolutionized what the fund industry calls passive management, or indexing. For decades this was a neglected corner of the market, left mostly to Vanguard Group, a non-profit company dedicated to cutting investment costs.
But then the Vanguard 500 Index (VFINX) eclipsed Fidelity Magellan (FMAGX) as the nation's largest equity fund, with assets currently of more than $80 billion, nearly $25 billion more than Magellan. Designed to do nothing more than replicate the performance of the stock market itself, Vanguard 500 trounced the majority of actively managed funds in the 1990s, including Magellan.
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So indexing was suddenly hot, and nothing has been hotter lately than exchange-traded funds. These are index funds that have unusually low expenses because they avoid some of the costs of running mutual funds, such as marketing and servicing shareholder accounts. S&P Spiders (SPY, news, msgs) have an expense ratio of 0.11% annually, or $11 on a $10,000 account. Vanguard 500 charges $18, and the average index fund $99.50, according to Lipper.
Last summer, Fidelity Investments, the only fund company bigger than Vanguard, took aim at this trend and slashed charges on five of its Spartan index funds to $10. Vanguard in turn has lowered the minimum investment required to take advantage of its lowest expenses, and it has introduced a growing number of ETFs, called Vipers, with even lower expenses.
"A lot of the reason fees are coming down is because of the larger number of index funds becoming available," says Richard Ferri, a financial planner in Troy, Mich., and author of "All About Index Funds."
Since 2000, what is called the asset-weighted average expense ratio of stock index funds has fallen 3.1%, to $28.10 on a $10,000 investment. That is, because the largest index funds have the lowest expenses, the $99.50 mathematical average for all index funds is effectively only $28.10, because investors put far more assets into low-cost funds than their higher-cost brethren.
When more costs less
Active management costs more than indexing because research costs money. The average expenses of a domestic diversified equity fund are $155.30 on $10,000 this year, up 4.9% from their level in 2000. That number would be much higher if index funds were excluded from the data.
The jump in fees doesn't reflect an increase in research costs. The cost of managing the money in a fund has been unchanged at $71.50 (on $10,000) since 2000. The entire increase is due to administrative and sales costs, and particularly the latter. Called 12b-1 fees, these marketing costs go to pay individual brokers at firms like Merrill Lynch, and directly to the company at discount brokers like Charles Schwab.
But the asset-weighted average expense ratio on equity funds has actually declined 2.2% in the last five years, to 0.878% or $87.80 on a $10,000 investment.
When expenses are spread over larger numbers of investors, unit costs can be low, even for actively managed funds. The expense ratio on American Funds Investment Company of America A (AIVSX), a fund with $62.56 billion of assets, is 0.57%. Fidelity Growth & Income (FGRIX) ($31.19 billion of assets) charges 0.69%. Dodge & Cox Stock (DODGX) ($44.39 billion) has a ratio of 0.53%.
It's not always true that the biggest funds are the thriftiest. According to Morningstar, Templeton Growth A (TEPLX) boosted its assets by $16 billion between 1989 and 2004, and still raised its expense ratio by 44 basis points, or 44 hundredths of a percentage point. Lord Abbett Affiliated A (LAFFX) grew by $11 billion but hiked expenses 41 basis points. (Lord Abbett says the increase was to pay 12b-1 fees, which are brokerage commissions in addition to sales loads. Franklin Templeton likewise attributed the increase in its ratio to 12b-1 fees, and noted that, at 1.10%, the expense ratio of Templeton Growth A shares is more than 30% lower than the average for its peer group.)
But bigger often means cheaper, and it's always worth checking out.
The killer Bs
Load-fund investors have one more cost hurdle to jump -- or, rather, to avoid. It's the "B" share chimera.
Brokers push B shares because they don't have front-end loads and therefore appear to resemble no-load funds. In fact, they pay brokers the highest sales commissions, in part because investors in them don't qualify for "break points," or commission reductions on investments of more than $50,000.
In the most egregious example, Dean Witter, now merged with Morgan Stanley, sold B shares almost exclusively, much to its brokers' benefit. It was later sued by investors, and bad publicity prompted a rush of promised reforms throughout the industry. Some firms that resisted selling B shares in the first place because of their deceptive nature are gradually dumping them, including American Funds.
B shares usually charge at least 75 basis points more in annual expenses than A shares. That's $75 on a $10,000 investment. They are also burdened with large redemption fees that linger as long as seven years, meaning investors lured into buying them are punished doubly if they try to correct their mistakes. They pay when they get into the fund and pay to get out.
Calvert Large Cap Growth Fund A (CLGAX) has an expense ratio of 1.61%. The B shares of the same fund (CLGBX) charge 2.61%. (This is not a large fund: Assets of the A shares are $251.3 million. B-share assets total just $24.1 million.)
The prevalence of B shares in the industry is one reason average expense ratios are so high. Almost without exception, brokers' customers can increase their net investment returns by choosing A shares over B.
Any discussion of fees puts the fund industry on edge, because cutting fees means cutting profits. Its trade association, the Investment Company Institute, massages the data to demonstrate a steady, consistent reduction in overall fees, to 1.25% for equity funds in 2003 from 1.35% in 2000, and from 2.26% in 1980.
That's eyewash. Lipper's data are far more authoritative; indeed, they are the industry standard. They show that investors have to shop carefully to avoid being gouged.
But you can do it. Indexing beats active management, because it's cheaper. Big funds beat small ones, because of economies of scale. Straightforward fund share classes like A beat deceptive ones like B. Taking advantage of these three simple facts can save you tens of thousands of dollars over a lifetime of investing.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Dodge & Cox Stock.
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