Despite recent gains in stocks, mutual funds have far to go

A good business

One industry that made money last year — and good money at that — was the mutual fund industry. Although fund-company earnings weren't as good as in a bull market, running the biggest funds remains a highly lucrative business. A fund that grows from $1 billion in assets to $10 billion in assets doesn't see a tenfold increase in expenses. Economies of scale mean that big funds are cash machines.

Last year, for example, the 25 largest stock funds pulled in nearly $7 billion in fees, according to estimates by Lipper. Of that $7 billion, about $4 billion, or an average $168 million per fund, went to management fees. Fund-management companies, like all other companies, have expenses people might not think of — nurturing smaller start-up funds, for example. Nevertheless, "The fund business is still a very good business," says Michael Lipper, president of Lipper Advisory Services.

The Investment Company Institute, the funds' trade group, points out that expense ratios have dropped 50% in every fund category since 1980, to an average 0.99 percentage points per investor. On the other hand, the industry's assets have grown to $10 trillion from $135 billion in 1980, a 7,000% increase.

Although 0.99 percentage points sounds small, expenses can have a big impact on your earnings. Consider two funds that earn 8% a year on their investments. Fund A charges 0.50 percentage points. Fund B charges 1.5 percentage points. A $10,000 investment in Fund A would grow to $87,500 in 30 years, vs. $66,000 for Fund B.

Morningstar's Kinnel says that some fund companies, such as Schwab and Janus, have been cutting fees lately, even though assets have fallen dramatically. Some other fund companies have been slashing corporate expenses and payroll to avoid having to raise fees.

But other fund industry moves are harder to defend:

•Fund implosions. Most people expect to lose money in a stock fund during a bear market. But a few bond funds melted down last year, producing losses that would be horrific for anyone. Oppenheimer Champion Income, a high-yield bond fund, plunged 79% last year. Schwab YieldPlus, a short-term bond fund, fell 35%.

•New funds. The fund industry often rolls out new funds to take advantage of short-term market trends. By the time the fund gets approval from the Securities and Exchange Commission to sell shares to the public, the trend is ready to reverse direction and roll over. Direxion Financial Bear 3x Shares, for example, promises to rise three times as much a day as financial-services stocks fall. The fund, which launched in November, plunged 77% in the second quarter, and has fallen 87% this year.

•New share classes. Most people buy mutual funds through a third party — a 401(k) plan or a broker, for example. To increase sales and mask the costs of paying the third party, funds have rolled out a bewildering array of share classes. Class A shares, for example, charge an upfront commission, or load. Class C shares have no upfront load, but higher ongoing expenses.

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