Investment Advice: Beware of Mutual Fund Fees

Photo: The cost of investing in mutual funds is going up.

The cost of investing in mutual funds is going up.

Thanks to the past year's market collapse, the expense ratios charged by mutual fund families are on the rise just as investors struggle to rebuild their portfolios. That means individual investors need to be more vigilant than ever about how much they are paying for a particular fund.

"Given the tremendous drops in assets industry wide, it's very likely expenses are rising and have already risen," said Russel Kinnel, director of mutual fund research for Morningstar Inc.

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Kinnel is the author of a new report showing why it is likely many mutual funds will be raising their fees at a time when many funds are off more than 30 percent in the past 12 months. His study of 2008 data shows that mutual fund expense ratios fell slightly last year, but a closer look indicates fund costs will rise this year.

The reason is that many funds have built-in break points that allow them to raise their expense ratios automatically when total assets fall to certain levels.

Kinnel also points to a recent announcement by the Vanguard Group that it would be increasing the expense ratios on many of its mutual funds in response to the drop in total assets it invests for clients.

"I think that's probably going to be common throughout the industry," Kinnel said in an interview. "It's just that Vanguard is a little more direct and open than other people are."

Most fund families will increase their fees without an announcement, he said.

Expenses ratios are a measure of annual costs charged by a mutual fund and are expressed as a percentage of assets. When a fund's total assets rise, the fund takes in more revenue to cover costs and generate a profit for the fund company. When assets fall, then the fund takes in less revenue.

At the end of February, mutual fund assets totaled $5.9 trillion, down from $8 trillion at the start of 2008. Without an increase in expense ratios, that would mean more than a 25 percent drop in revenue for fund families.

The decline in market values is not the only reason for the huge drop in mutual fund assets. A second factor is the fact that many investors liquidated their mutual funds and jumped into cash in response to the markets' collapse.

Kinnel said exchange-traded funds -- a cheaper alternative to mutual funds -- should not experience the same type of price increase because investors have actually poured more money into ETFs recently rather than take it in response to the market drops.

His research shows that in 2008 the asset-weighted average annual expense ratio for retail mutual funds fell from .88 percent to .87 percent. But that dip is based on expenses averaged out for a 12-month period as opposed to more timely data.

"Because assets today are down 30 percent to 60 percent from January 2008 at the typical equity fund, the 2008 expense ratio figures don't include the full effect of a fund's current fee structure," Kinnel wrote in a report published last week.

To gauge where expense ratios are headed, Kinnel looked at what is called the "prospectus net expense ratio," which is current as of the day a mutual fund prospectus is published.

Based on that prospectus net expense ratio, some funds may see their expense ratios this year rise by .20 percentage points or more. According to Kinnel's research for Morningstar, funds in this category include American Century Small Cap Value, Artisan Small Cap and Greenspring.

Given that many mutual fund investors have experienced losses in excess of 30 percent, a .20-percent expense ratio increase seems hardly worth mentioning.

But keep two things in mind. First, expenses compound over time.

Imagine today you invest $100,000 each in two mutual funds. They are identical in all ways except for one -- the fees they charge. One charges a .50 percent expense ratio; the other 1.5 percent.

Then suppose over the next 25 years they both post the same pre-expense return of 7.5 percent per year. That means an after-expense return of 7 percent for the cheaper fund and 6 percent for the more expensive one.

What does that 1 percentage point difference amount to for you, the investor, over 25 years? It's nearly $114,000.

A second thing to keep in mind about fund expense ratios is that there is a connection between expenses and performance. The lower the cost for a fund, the more likely it is to be a top performer.

"Many studies have indicated expenses are the best predictor of future performance," Kinnel said. He recommends looking for funds that rank in the bottom 20 percent for expenses in a given fund category.

Follow that process, and your chances of selecting a top performer increase dramatically.

That's something to keep that in mind as you try to rebuild your portfolio for the years ahead.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.

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