Is Your Mutual Fund Ripping You Off?

Is your mutual fund a rip-off? If its expense ratio is above -- or even at -- industry averages, it may well be.

At the mention of fund expenses, many investors counter that they'd much prefer to pay fees of two percent to earn 20 percent returns than pay 0.5 percent to earn eight percent. Of course, that's inarguable. But as alluring as past performance can be, expenses are the single best predictor of future performance.

As recently as 2006, Bill Miller was a true rock star in the mutual fund world. His Legg Mason Value Trust had famously outperformed the S&P 500 for 15 consecutive years, an accomplishment that most of his shareholders used to justify paying a higher-than-average expense ratio (which is currently 1.68 percent).

Since then, the fund has fallen on hard times, and its performance the past three years has been so poor that the fund's annualized ten year return of minus seven percent now lags the S&P's minus three percent return by four percentage points. A once-awe inspiring track record has been decimated.

PIMCO's Bill Gross meets anyone's definition of a successful fund manager. But if in 2000 you had paid the 3.75 percent load to purchase PIMCO's Total Return fund -- with a current expense ratio right at its category's average -- you would find yourself slightly lagging the Barclay's US Aggregate Bond Index through March.

It's hard for many investors to work up a lot of interest in their mutual funds' expenses. And for good reason: they're relatively small numbers. We're talking about a percentage point or two in most cases; perhaps even less. So it's easy for an investor who wouldn't dream of making a trip to the grocery store without checking the weekly flyer to overlook a "mere" percentage point or so in increased expenses.

But they're exceedingly important. Compounded over 40 years, paying just an extra 0.5 percent in annual expenses on an eight percent return would reduce the growth on a $10,000 investment from $207,000 to $170,000, leaving you with just over 80 percent of what you might have earned. In this case, that seemingly small difference in expenses would have provided you with enough to purchase a very nicely-equipped car. You'd have to clip 925 "dollar off" coupons each year for 40 years to save that same amount.

The table below shows the average expense ratio for a few different types of mutual funds. If the expenses of your funds are higher than the figures below, you're paying too much, plain and simple. Regardless of how brilliant your fund manager may appear to be today (or, likely more accurately, appeared to be in 2007), the simple fact is that the higher your fund's expenses, the lower its long-term returns will be.

But here's a dirty little secret: even if your funds' expenses are hovering near the category averages, you're still paying too much. Why? Because expense ratios have a stubborn tendency to move in only one direction: up.

There's very little incentive for mutual fund managers to lower fund fees, and a great deal of incentive to keep them as high as possible. While lowering fund fees benefits you as an investor, it takes money directly out of the manager's pocket; no one likes having money taken out of their pocket.

And because most investors pay far more attention to past returns than to expense ratios, mutual fund managers are able to hold expense ratios steady over time -- or even increase them -- reaping the tremendous economies of scale that asset management provides.

Consider Massachusetts Investors Trust, or MIT, the industry's first mutual fund, founded in 1924. In 1993, the fund had total assets of $1.6 billion and charged an expense ratio of 0.68 percent, meaning that the fund's manager, MFS Investment Management, was paid roughly $11 million to manage the fund. Currently, MIT's assets are $2.5 billion, and that expense ratio has actually increased, to 0.97 percent, bumping the management fee to some $25 million.

So while assets were increasing 1.6-fold in the past 15 years, the management fee was increasing even faster, by nearly 2.2-fold. If you believe that the expenses of running a $2.5 billion dollar fund are more than twice those of running a $1.6 billion fund, you're either hopelessly naïve or a creative cost accountant.

But if we might understand why an investor would (misguidedly) overlook high expenses in the hopes of catching on with the industry's next great stock pickers, it's inconceivable why anyone would overpay for a bond or money market fund, for a few basic reasons.

First, because the returns of these two asset classes have historically been more modest than those provided by the stock market, costs take a much higher relative bite out of what you finally earn.

Second, money market and bond funds (particularly government bond funds) are essentially commodities -- one Treasury money market fund is not going to differ much from the next, just as one intermediate-term government bond fund has a portfolio that is practically indistinguishable from the others in the category.

Yes, some managers might reach for yield by increasing their fund's credit risk (we're looking at you, Reserve Primary Fund), and others might alter their fund's holdings in anticipation of interest rate changes, but by and large, there's far more homogenization in bond and money market portfolios than in equity fund holdings, which is why it makes no sense whatsoever to overpay for these types of investments, unless you like the idea of increasing your fund manager's profits.

So what sort of expense ratio is reasonable? It depends on the type of fund, of course, but a good rule of thumb is to aim for an expense ratio that is half the category average; perhaps 75 percent of the average if you really need to expand your options. There are enough options in this range in each category that you should never have to consider a fund with expenses that even approach their category's average expense ratio.

No matter how compelling the track record, remember that performance comes and goes. History clearly demonstrates that expenses are the only - only - enduring predictor of future performance. As we've been reminded over the past year, investing is a brutal game, and there's no reason to enter the playing field without maximizing every possible advantage. So do yourself and your portfolio a huge favor: cut your investment costs and boost your returns.