Most people think the skill of the portfolio manager is the only thing that determines how a mutual fund performs. If the manager does a good job buying and selling stocks or bonds, investors figure, that's all that matters. In fact, this is what's reflected in the performance reports that come out on funds every three months.
But the investor's profit never exactly matches the gains made by the portfolio manager. The investor's figure is reduced by the "expense ratio," which funds shell out for management fees, day-to-day operating costs, such as legal and accounting fees, shareholder servicing expenses and overhead. And, if the fund has a 12b-1 fee to help pay for marketing and sales commissions, the return to the investor is even less.
Some funds' expenses reduce the investors' gain only by half a percentage point or so. But at about 40 percent of the stock funds, annual expense ratios are 3 percent or more, says Norm Fosback, editor of Mutual Fund Forecaster, a newsletter published in Fort Lauderdale, Fla.
By and large, Mr. Fosback says, those funds don't perform very well. "Funds with high expense ratios underperform by just about the amount of the expense ratios," he says. So that means investors aren't getting anything for the higher expenses.
In fact, in the long run, they're losing quite a bit. To illustrate how much, Mr. Fosback recently figured how much would be lost in an equity fund with various expense ratios over different time spans. If $10,000 was put into a fund with a 0.5 percent expense ratio and the portfolio grew 10 percent a year, a shareholder would have $5,742 after five years, $14,782 after 10 years, and $51,416 after 20 years.
With a 1 percent annual expense ratio, assuming the same $10,000 investment and 10 percent return, the five-year total falls to $5,386; for 10 years, it's $13,674; and for 20 years, the total is $46,044. At 2 percent, the five-, 10- and 20-year tallies are $4,693, $11,589, and $36,610. Thus, over 20 years, the 1 1/2 percent difference between a fund that charges 0.5 percent of assets for expenses and one that costs 2 percent is $14,806.
With some funds, a fairly high expense ratio may be worthwhile. "If it's an aggressive growth fund where a top-flight manager is getting 20 percent a year, [the expense ratio] is not as big a deal," says Don Phillips, editor of Mutual Fund Values, published by Morningstar Inc. in Chicago. More aggressive funds sometimes have higher expenses because the portfolio managers are buying and selling securities more often, which involves transaction costs.
Also, Mr. Fosback says, expense ratios are sometimes higher for small funds that have to spread fixed costs among fewer shareholders. But often, the difference is simply a reflection of management's desire to keep costs low for investors, vs. the temptation to make more profits for the fund company and its managers.
Low expenses aren't exclusive to no-load funds, which have no sales charge, Mr. Fosback adds. There are some load-fund rTC companies, including the American Funds Group, IDS Funds and the United Funds Group, with expense ratios ranging from 0.6 to 0.9 percent. While a load fund has a sales charge at the beginning, if you stay with the fund for several years, its effect is minimal.
Among no-load funds, the lowest is the Vanguard Group, with 17 funds charging half a percent or less.