Mutual funds are one of the most important innovations of all time for individual investors, allowing them to obtain wide diversification and professional investment management at reasonable cost. That makes it the more shameful that large portions of the mutual fund industry continue to exploit shareholders with excessive costs, while delivering below-average returns.
Some fund companies offer very inexpensive products. Investors in funds offered by Vanguard, TIAA-CREF, Dimensional Fund Advisors, and others can buy into the stock and bond markets at the same low cost enjoyed by large institutional investors.
Other mutual fund companies are hurting their investors by offering funds with high fees, suggests a recent study by Morningstar Inc., an independent rating service. Costs are expressed by each fund’s expense ratio, which measures the expense of operating a fund—brokerage commissions, record keeping expenses, the portfolio manager’s salary—as a percentage of the assets of the fund. Morningstar looked at all mutual funds with $100 million or more in assets during 2001 and found 30 that had annual expense ratios of 2% or greater, which is about double the industry average. By comparison, the lowest-cost mutual funds had expenses as low as 0.15%.
The study backs up a finding of much academic investment research: higher investment costs, on average, are accompanied by lower returns. Many of the 30 funds that had higher expenses did not perform as well as the average of their peer groups. For instance, the AIM Large Cap Opportunities Fund had an expense ratio of 2.34%, Morningstar said. (AIM disputes that figure. It estimates 2001 expenses at 2.12%.) The fund’s performance wasn’t so hot last year. The fund lost 26.6%, placing it in the 67th percentile of the large-cap-growth category, below average for all funds in that group.
Another fund with high expenses, the Kelmoore Strategy Fund, Class C Shares, had expenses of 2.41%, according to Morningstar. The fund invests in stocks, covered call options, and secured put options, placing it in the 97th percentile of Morningstar’s “hybrid” funds category last year. That was virtually the bottom of the heap as it lost 13.7%, following a loss of 15.1% the previous year.
Mutual fund investors cannot control the market’s investment results, but they can control their cost of investing. They should compare a fund’s expenses to its peers before taking the plunge. Funds with higher than average expenses should be avoided.
Every month Morningstar publishes a list of average expenses for dozens of fund categories. For instance, the most recent list shows that the average large company domestic stock fund has an expense ratio of 1.24%.
Other types of funds may have higher or lower expenses. It costs more to invest in small and international stocks, but investors still should not overpay. The average domestic small stock fund has an expense ratio of 1.41%, and the average large cap foreign fund has expenses of 1.65%, according to the most recent Morningstar survey.
