Mutual Funds
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| | Mutual Funds
The real Wall Street rip-off? Fat fund fees
Here is an idea: Keep more of your own money in your pocket by paying fewer fees. Just shelling out 0.2% more in fees each year can rob you of thousands in profits over the long haul.
By Timothy Middleton
Even if you weren't an investor in the funny-business funds targeted by New York's attorney general, there's still a good chance you're getting robbed by the fund industry.
Put simply, most funds charge you too much to invest in them.
We should expect vast economies of scale in the money-management business, and they do not appear to be passed on to the extent they are realized, says Edward ONeal, a finance professor at Wake Forest University's business school who specializes in fund expenses.
They certainly havent. Between 1994 and 2000, the assets of U.S. stock mutual funds soared 408% to $735.36 billion, according to fund tracker Morningstar. But fund expenses actually climbed more, 438%, to more than $10 billion from less than $2 billion. The average expense ratio expanded to 1.43% from 1.35%.
What's the explanation for this? Avarice. The expense ratio, which every fund must make public, covers fixed overhead such as salaries, rent and research. As anyone whos run a lemonade stand knows, fixed overhead goes down in percentage terms as sales go up. The kinds of costs that increase as assets grow, such as trading expenses, arent even captured in a funds expense ratio.
How pennies add up to big bucks
There are two ways fund investors can put a lid on annual expenses. The first is to index. Vanguard 500 Index Fund (VFINX), which has outperformed nearly 80% of similar funds over the last 15 years, charges 18 cents per $100 invested. Large-cap blend funds, a good group to compare the Vanguard fund against, charge an average of $1.08. The difference after a little compounding is considerable.
The other approach is to shop for low-fee funds. Since every penny taken as an expense subtracts directly from performance, low-fee funds are better. There are exceptions, and one of the most glaring is Legg Mason Value (LMVTX), whose annual charge is $1.72 per $100 invested. The fund's performance is exceptional -- it has beaten the S&P 500 ($INX) by 2.68% annually for 15 years. But that's not good enough to justify the price tag.
What possible difference can a few pennies a year make? Heres an example.
Over a 30-year investment career, a $100,000 portfolio that generates gross returns of 10% annually will skyrocket to $1,745,000. If that performance is reduced by 0.2%, an index fund-size expense ratio, you end up with $92,000 less. If the cost is 0.8%, which is around the asset-weighted average for large-capitalization funds, you pay $343,000. If the ratio is 1.08%, the simple average, your total cost is $447,000. If the ratio is 1.72%, as it is at the Legg Mason fund, you have lost out on $657,000 -- more than one-third of your profits.
If you think you can beat those odds with a superstar manager, remember this: The average manager tenure at a fund like this is four years, according to Morningstar. You could go through a half dozen of them.
Funds worth their fees
OK, you say, but what about long-tenured managers at market-beating shops? Cant they earn their keep?
My answer is a resounding yes. Thats why I index only a portion of my personal assets. There are Ferrari funds with Ford prices. But this metaphor is misleading; mutual funds arent cars, theyre cabbages. Theyre a commodity. Over long periods, the top funds perform similarly.
Over the 15 years ended July 31, the spread in annualized returns among the top five funds in Morningstars large blend category, the Vanguard 500 Index type, was between 14.1% at the bottom Vanguard Primecap (VPMCX) and 15.9% at the top Fidelity Contrafund (FCNTX).
The spread in expense ratios among the five was nearly the same, a low of 0.49% for Primecap, a high of 1.72% for Legg Mason Value Trust, which ranked No. 4. But the Legg Mason fund was the only one with a high expense ratio; the other four were well below the category average.
If you had been shopping for these funds 15 years ago, the odds would've been in your favor in the case of all but the Legg Mason fund. (The other two in this group are Mairs & Power Growth (MPGFX) and Hartford Capital Appreciation (HIACX).) The odds were very definitely against you at the Legg Mason fund.
What you should pay
So what should you pay in expenses? A useful guideline is the average for the best funds in a group. This will usually be lower than the average for the entire group, because performance is pulled down by expenses, one-to-one.
That average will vary by fund type. Bond-fund expenses must be, and are, lower than equity-fund expenses, held down by lower gross fixed-income returns. It costs more to run a small-cap than a large-cap fund, because research is harder and therefore more expensive to come by. Ditto foreign-stock funds.
Here are my fee recommendations. Generally speaking, the top-performing funds in each category have expense ratios around this level. These numbers aren't asset-weighted; you should be able to do better at large funds, and better still with index funds.
| Maximum affordable expense ratios | | Type of fund | Average expense ratio in % | You should pay no more than ... | | Large cap | 1.25 | 1 | | Mid cap | 1.59 | 1.15 | | Small cap | 1.58 | 1.15 | | Sector | 1.51 | 1.10 | | Municipal bond | 1.13 | 0.55 | | Taxable bond | 1.10 | 0.80 | | High-yield bond | 1.40 | 0.95 | | International | 1.72 | 1.35 |
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Sources: Morningstar, MSN Money
Should you ever violate my expense rules? Well, I do.
I control shares of Bjurman Barry Micro-Cap Growth (BMCFX), whose 1.59% expense ratio is far higher than my recommendation of 1.15% for its group. But Bjurman is an extremely small shop. The funds assets are only $235 million, and the firm only manages one other fund. Fees are spread across relatively few shareholders.
This fund has other qualities that justify outsize expenses. It's managed to maintain its small size (it currently is closed to new investors) because that is vital among the tiny companies (an average market cap of $288 million) in which it invests.
The funds performance has been stellar -- a total gain since inception in 1997 of 357%, compared with a minuscule 7.1% advance in the Russell 2000 Growth Index. I couldnt have predicted this success based simply on the expense ratio. But I made informed allowances for it.
I have been willing to make no such allowance for the Legg Mason fund because its just not good enough. Aside from Vanguard 500, my favorite large-cap fund is Clipper (CFIMX), whose expense ratio is 1.07% and which (surprise) has outperformed Legg Mason in the same 15 years by roughly the difference in expenses, 14.8% to Masons 14.3%.
As in gambling, investors should keep the odds on their side. Low expenses are powerful odds-makers.
At the time of publication, Timothy Middleton owned or controlled shares in the following securities touched on in this article: Bjurman Barry Micro-Cap Growth, PBHG Clipper Focus, and a non-public S&P 500 index portfolio in a separate pension fund account.
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