Fund fees are falling, but there's a catch

Mutual fund expense ratios for the average investor are declining. Morningstar reported last month that the decline is due to investors wising up and moving out of expensive mutual funds into lower-cost funds such as index funds.

According to Morningstar, the average mutual fund charges 1.25 annually, but the weighted average charge (calculated by giving more weight to bigger funds) is only 0.71 percent annually. In addition to expense ratios, funds have hidden costs such as trading fees. Fortunately, these costs are also declining, and Russel Kinnel, Morningstar's director of fund research, tells me a 0.90 percent annual total expense is a reasonable estimate.

While this is all good news, it must first be framed in the context of future market returns. With interest rates unable to decline much more, the 30-year bond bull is over. And the current rich stock market valuations have many predicting they won't last and much lower returns are likely over the next decade.

Second, the news must also be framed in the context of real, after-inflation, returns. That's because the only thing that matters is how spending power will grow over time.

So, let's now take a look at fees as a percentage of expected future market returns over the next decade. We'll assume the portfolio comprises half stocks and half bonds.

Acknowledging that no one knows how markets will perform, a Vanguard paper does offer some insights. The data it provides illustrates an expectation of a 5.7 percent real return for stocks and only about 0.5 percent for bonds. This equates to an overall real return of about 3 percent for the portfolio.

William Bernstein, author of the new book Rational Expectations, told me he thinks Vanguard is being overly optimistic. He sees stocks returning closer to a 3 percent annual real return and a negative 1 percent real return on bonds, which equates to only a 1 percent annual real return for the portfolio.

Both Vanguard and Bernstein note the future is always very uncertain. But averaging the 3 percent Vanguard forecast with the 1 percent Bernstein forecast, results in a 2 percent annualized return expectation from this portfolio of half stocks and half bonds.

When framed against more modest expectations of a 2 percent real return, that 0.90 percent in annual total fees estimated by Morningstar doesn't look so low. It actually looks like the average investor is still giving up 45 percent of future expected returns (0.9 divided by 2) while taking on 100% of the risk.

The solution, of course, is to pay lower-than-average fees. Some total stock and bond index funds have expense ratios below 0.10 percent, which means you're giving up only about 5 percent of the real return rather than almost half.

It's a really good thing that expenses are trending down, but framing your fees against realistic expectations of future returns will help you to understand just how important those fees really are.