Expense ratio of fund needs scrutiny

Reports can show if it's behaving in line with evolving assets

Dollars & Sense

January 27, 2002|By Gregg Wolper | Gregg Wolper,MORNINGSTAR.COM

In the coming months, many of you will be receiving your funds' 2001 annual reports. That would be an excellent time to check to see if your funds care as much about costs as you do.

You already know the importance of considering expenses when choosing mutual funds. What you may not know is that there are ways to go beyond simply comparing one fund's expense ratio against those of its peers. One often-overlooked point, for example, is whether a particular fund's expense ratio is behaving as it should in relation to the growth or contraction of the fund's asset base.

Look at the fund's history: Regardless of whether its current expense ratio seems reasonable compared with those of its peers, how does it stack up against the fund's own figures in the past? Is your fund's expense ratio falling as much as it should as assets have grown? Is it rising even though assets have remained stable?

Because fund companies don't relish the idea of shareholders digging into these numbers, they make it tough for you to do so. On their Web sites, they list only the current expense ratio, and they rarely discuss the subject in the managers' comments. But by doing a little work, you can check the progress of a fund's expense ratio over time in its annual and semiannual reports.

Each year's figure is listed in a table, usually called Financial Highlights. That table is typically buried toward the back of the booklet, but is sometimes near the front. It's separate from the standard financial statements such as the Statement of Operations. Near the bottom of the Financial Highlights table appear lines for expense ratio and net assets, right next to each other, so you can easily see if they are rising or falling in the proper relation to one another.

Templeton Developing Markets, the big fund run by well-known manager Mark Mobius, provides an example of a fund whose costs bear close scrutiny. To start with, its expense ratio, which has been around 2 percent or so for years, is too hefty for an offering with assets in the billions of dollars, regardless of the added costs of emerging-markets research.

Worse, the fund's expense ratio has been heading in the wrong direction. From the end of 1999 to the end of 2000, the expense ratio for the fund's A shares rose to 2.09 percent from 2.02 percent. That was understandable, at least, because the net assets over that stretch dropped to $1.51 billion from $2.96 billion.

But in the first half of 2001, the fund reports that its annualized expense ratio climbed all the way to 2.17 percent from 2.09 percent, even though in that period assets stayed essentially flat. Even if the asset base fluctuated over that stretch (the expense-ratio calculation is based on daily assets rather than just the final figure), that jump in the expense ratio can't be justified. Clearly, keeping a close eye on expenses is not Franklin Templeton's prime concern.

In fact, a fund's expense ratio need not rise even if its assets have declined. On occasion, many fund advisers will partially subsidize the expenses of a fund; in other words, they'll pay some costs out of their own pockets instead of from the fund's assets. That's most common with new funds whose expense ratios would otherwise be astronomical because they have so few assets.

But sometimes advisers subsidize mature funds, too. If they are doing so, they disclose it in a footnote to the expense ratio. If your fund's expenses are rising and the adviser isn't subsidizing - even subsidizing a little bit shows the fund company is aware that costs matter to you - let management know you don't appreciate being taken for granted. Fund companies won't cut costs out of the goodness of their hearts. But if you tell them you're watching that expense ratio and know full well the fund's history in that regard, then just maybe they'll respond.

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