Be Smart About Mutual Funds Without the Court's Help

Nov. 3, 2009 — -- Don't wait for the U.S. Supreme Court to act; take matters into your own hands.

That's my advice for mutual fund investors looking to cut their investment costs after the Supreme Court on Monday heard arguments in a case about whether investors can sue mutual fund firms if they think the fees they charge are too high.

I'm rooting for the individual investors suing Harris Associates LP, owner of the Oakmark mutual funds. But for many individual investors, there's no reason to wait for a Supreme Court ruling expected next spring.

They can act now by pulling their money out of the Oakmark funds or any other mutual fund that charges too much.

There are numerous lost-cost options, including the Vanguard family of funds, index funds from Fidelity, Schwab, T. Rowe Price and others, and exchange traded funds that are ridiculously cheap.

There's just no reason to be paying more than 0.50 percent a year for mutual fund fees. There are plenty of good options that cost less than that, and the simple fact is the less you pay, the more you keep in terms of earnings.

The sad truth, however, is that too few investors pay attention to what they're paying their mutual fund managers. The average stock mutual fund charges an expense ratio of 1.44 percent, according to the Investment Company Institute, the fund industry's trade association.

The association likes to use an asset-weighted average, that takes into account the size of funds, to show the average expense ratio paid by an investor was 0.84 percent in 2008.

That's a perfectly valid presentation. However, I like to look at it from the perspective of the individual looking to invest and has to choose among nearly 8,900 mutual funds, many of which exist in multiple versions.

More than half of the funds listed in the Morningstar database carry an annual expense ratio in excess of 1 percent, and more than a quarter feature one of more than 1.5 percent. So the chances of an individual landing in a high-cost fund are quite high.

Low-Cost Mutual Funds

The average 1.44 percent expense ratio for stock funds amounts to $144 on a $10,000 balance. That doesn't sound too bad. But compare that figure to the .07 percent charged by the Vanguard Total Stock Market ETF, one of the lowest-cost exchange-traded funds around. The annual expense in that case amounts to $7.

Look at it another way. Imagine two funds with an identical pre-expense return of 8 percent annually. The high-cost fund with a 1.44 percent expense ratio would see its annual rate of return reduced to 6.56 percent. A low-cost exchange traded fund with a .07 percent expense ratio would see its after-expense return drop to just 7.93 percent.

Over the course of 30 years, the difference between 7.93 percent and 6.56 percent adds up – or, I should say, compounds – in a big way. At those rates, a $10,000 initial investment would grow to about $67,000 in the high-cost fund and to about $99,000 in the low-cost ETF.

The low-cost option would leave the investor with one-third more money to spend in retirement.

That's why the Jones v. Harris Associates case is important to investors.

The mutual fund industry and other opponents of the case against the Oakmark funds point out that the mutual fund business is extremely competitive and individual investors can express their displeasure with fees by moving to lower cost funds.

And they are right – to a degree. Assuming they do not need to worry about paying capital gains taxes, many mutual fund investors are free to flee from the strangle of outrageous fund fees. But this assumes the investor owns the fund outside of an employer-sponsored retirement plan.

The reality is that many investors do not have such freedom. One-third of all mutual fund assets are held in employer-sponsored defined contribution retirement plans such as 401(k) and 403(b) accounts.

Typically, workers investing in these plans are restricted to a menu of funds chosen by their employer and too often, these menus are dominated by high cost funds.

So the free-choice argument against the Oakmark funds lawsuit is not so clear cut.

But I say, if you have a choice, act now. Take your investment dollars to a fund company that allows you to keep more of your earnings.

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.