Mutual fund investors who pay less get more

By Meg Richards
Associated Press

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Comparing fund fees To see how your mutual fund stacks up against others in the fees it charges, look at its total expense ratio. The annual expense ratio, taken from the fund's annual report, reflects the percentage of assets deducted each fiscal year for fund expenses. To check the expense ratios for mutual funds, go to morningstar.com (you may need to register) and click on the Funds link. Source: Morningstar.com

S&P, a provider of independent investment research, ratings and indexes, maintains a database of more than 3,000 mutual fund portfolios. In its second annual study of performance and fees, it found that funds with lower expenses outperformed their pricier counterparts in eight of nine investment styles.

For the second year in a row, the only place investors got an edge by paying more was in the mid-cap blend category, where funds with higher expenses did better over five- and 10-year periods than those with lower expenses. S&P researchers attributed this to the recent success of small-cap stocks, which were available to many mid-cap blend managers.

"The mid-cap blend is the ultimate non-style," said Phil Edwards, managing director of S&P's investment services department. "They can reach up or reach down, and the ones that reached up into large caps suffered, and the ones that reached down into the small caps did well. In that one sector, the higher expenses won."

Despite this anomaly, the study underscores something professional investors have known for a long time: Paying more doesn't necessarily get you a better deal on Wall Street.

"The philosophy that you get what you pay for should not be applied to mutual fund selection," said Eric Tyson, author of "Investing for Dummies."

If you think about what it takes to be a successful mutual fund company, Tyson said, you have to consider the economy of scale: As a fund manages more money, it spreads its fixed expenses over a larger set of assets.

"That means you should be able to buy better fund management at a lower cost," Tyson said.

Regardless of how many assets they hold, large-cap funds generally charge the lowest expenses, as larger stocks are easier to trade and the issues that affect them are usually well-known. Small-cap stocks are less liquid and often require more research on the part of the fund manager, so paying more for active management in that category has traditionally made sense.

The average expense ratio for large-cap funds tracked by S&P is about 1.16 percent. For mid-cap funds it's about 1.13 percent, and for small-cap funds it's about 1.35.

The average expense ratio for bond funds is about 1 percent.

If you own a passively managed index fund, the expenses are even lower — perhaps 0.25 to 0.30 percent.

If you're not sure what you're paying, you can go to the fund sponsor's Web site and look for the prospectus, which typically includes a table with the expenses, and whatever loads — sales commission paid to brokers — that apply. For investors who don't take the time to calculate the costs, high expenses can take a serious bite out of mutual fund returns over time.

Part of the problem, Edwards said, is that fees are expressed in percentage rather than dollars and cents. The fact that they are costs that will be incurred in the future may also make them seem less ominous.

"A lot of people are more worried about paying their $50 cable bill than a percent and a quarter on their investment every year," Edwards said. "But let's say you have a retirement account with $50,000 in it; that's $625 a year, every year. Not just one year, but every year. ... It adds up."

That means as your investment grows, so do your costs.

There also are other costs that might be tricky for a novice to dissect. For example, your expense ratio may be 1.25 percent, but you may also be paying a 0.25 12b-1 fee, which is supposed to cover the cost of advertising and selling the fund.

What's confusing is that some funds charge these marketing fees even after they've closed to new investors. There also may be other charges, such as trading costs, that are not clearly disclosed. This has caused many industry watchers to call for reforms in mutual fund fees.

Edwards and other experts say fees are one of the first things you should consider when you're deciding whether to buy or sell a fund. Other fundamental criteria include consistency of performance, quality and consistency of management, the style of the fund and whether it is appropriate for you, and the quality of the fund sponsor.

The only time high expenses might be called for is if you're buying into a brand new fund with lower asset levels, said Tyson. Even then, you should think carefully about whether you want to buy into a fund without a performance history.