Beware mutual fund fees: they add up to serious money

PERSONAL FINANCE

December 21, 2003|By EILEEN AMBROSE

THE MUTUAL fund industry probably wishes New York Attorney General Eliot Spitzer would just go away.

Instead, Spitzer told a Senate committee last month that he's now setting his sights on excessive fund fees, the "logical next step" for his fund investigation.

Each of the 54 million American households investing in funds last year paid an average of $1,292 in fees, and that doesn't include trading and other costs passed on to investors, Spitzer said. Fees often are poorly disclosed, and investors deserve to know whether these expenses are fair, he said.

Keeping to his word, Spitzer last week negotiated a settlement with Alliance Capital Management, accused of allowing improper trading in its funds, that requires the company to reduce its fees by 20 percent and keep them at that level for at least five years.

Some experts say it's about time someone tackles high fees, which take a far bigger financial toll on investors than market timing and after-hours trading abuses recently uncovered among some funds.

Assets in mutual funds have reached $7 trillion, up from about $2 trillion in 1993. Many fund companies haven't passed along the savings they achieved through economies of scale as assets have grown, said Russel Kinnel, director of fund research at Morningstar Inc.

"Considering the costs are more or less what they were 10 years ago when assets were much smaller, it doesn't make sense," he said.

Kinnel blames fund companies, which figured investors wouldn't pay attention to fees as long as they earned healthy returns in the 1990s, and the fund directors that OK'd the fees.

Some, however, argue that the marketplace, not regulators, should determine fees.

The marketplace works because the funds with the lowest fees tend to have the most assets, said John Collins, a spokesman for the Investment Company Institute, a trade association for mutual funds.

Regulators and legislators are proposing ways to make fees more transparent to investors.

And the institute last week recommended limits on so-called soft dollars, where funds pay slightly higher commissions to brokerages in return for, say, research or computers. Instead of fund companies paying for these perks themselves, shareholders foot the bill.

But investors don't have to wait for the industry to change to start saving money. Stop chasing last year's winning funds and instead look for those with low fees, experts said.

"People need to become more aware of and understand that every percentage you pay in fees is reducing the return you earn on that investment," said Edward O'Neal, a finance professor at Wake Forest University.

Here are things to look for:

Total expense ratio. Listed in the prospectus, this figure tells you the percentage of assets you'll pay each year for money management, administration and distribution.

How high is too high? Shop and compare, says Robert Mewshaw, president of the Van Sant & Mewshaw, an investment adviser in Lutherville. One easy way is to look at the expense ratio of an actively managed fund, compared with the expenses of an index fund with a similar investing style, he said.

Index funds mimic a benchmark, such as the S&P 500 index, by holding similar securities. There's little turnover and no active manager, so fees tend to be very low.

Say a large-cap index fund charges 0.20 percent each year, where an actively managed large cap fund charges 1 percent, Mewshaw said. "What are you getting for that extra 80 basis points? That's what an investor has to ask himself," Mewshaw said.

Some say it may be worth paying a little extra if the fund produces great returns year after year. But you're paying too much if fees are above average and your returns aren't.

Turnover. The trading costs that occur when a fund buys and sells stocks aren't included in the expense ratio. Investors can get an idea if they'll be paying a lot in trading costs by looking at the fund's turnover rate in the prospectus, O'Neal said.

It's not unusual for U.S. stock funds to have 100 percent turnover, which means the fund sold all of its shares and bought new ones over the year.

"Greater turnover obviously leads to greater brokerage commissions and trading costs," said O'Neal, which is why he favors low-turnover index funds.

Commissions. If you buy a fund through brokers - rather than directly from the mutual fund company - you'll be paying for their advice. How they are compensated depends on the class of shares purchased.

Class A shares, for example, generally charge an upfront fee of 4 percent to 5 percent and a small annual fee for marketing and distribution, called a 12b-1 fee. Invest a sizable amount at once or over time and you may be eligible for a discount on the sales charge.

Class B shares don't carry upfront sales charges, but investors will pay a higher 12b-1 fee and a back-end charge if they sell the fund within a few years.

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