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Mutual Fund Fees Jump 5 Percent

After one of the most awful years in the history of the mutual fund industry, when the average U.S. stock fund and international fund fell by 39 percent and 46 percent respectively, you might expect fund companies would give investors a break and lower their fees. But just the opposite is true.

An exclusive analysis for by investment research firm Morningstar shows that over the past year, fund fees have risen in nearly every category. For stock funds, the fees shot up by roughly 5 percent. (Putnam and Schwab have made hay about lowering some of their fees recently; more on that later.)

in Fees
a Year Ago
U.S. Diversified +.06 1.37% 1.31%
Domestic Equity +.05 1.39% 1.34%
Int’l Equity +.08 1.56% 1.48%
Taxable Bond +.01 1.04% 1.03%
Municipal Bond +.01 1.03% 1.02%
Asset Allocation -.03 1.30% 1.33%
Source: Morningstar

According to Russel Kinnel, director of Mutual Fund Research at Morningstar and author of Fund Spy, the rising fees are actually a result of last year’s market plunge. Funds charge a percentage of assets under management, so their revenue drops when the market declines. To compensate, they charge customers more. It helps to understand the break points most fund families have in their management fees. A fund managing $2 billion might charge 1.5 percent on the first billion dollars under management and 1.0 percent above that, for an average fee of 1.25 percent. Along comes the market plunge, assets shrink to a billion dollars, and the fund now charges 1.5 percent, a 0.25 point increase. Even Vanguard, which mostly just prices its funds to cover costs, has boosted fees by an average of 0.05 points, according to Rebecca Cohen, Vanguard public relations manager.


Why You Should Care About Fees

Every penny you pay in fees, of course, lowers your return. In fact, my research indicates that each additional 0.25 percent in annual fees pushes back your financial independence goal by a year.

What’s more, the only factor that is predictive of a fund’s relative performance against similar funds is fees. A low-cost domestic stock fund is likely to outperform an equivalent high-cost fund, just as a low-cost bond fund is likely to outperform an equivalent high-cost fund. For proof, take a look at the graph below from my recent book, How a Second Grader Beats Wall Street. As fund fees increase, performance decreases. In fact, fees explained nearly 60 percent of the U.S. stock fund family performance ratings given by Morningstar. Numerous studies done to predict mutual fund performance indicate that neither the Morningstar rating nor the track record of the fund manager were indicative of future performance.

Betting Against the Most Powerful Force in the Universe

The power of compounding — what Albert Einstein once called the most powerful force in the universe — makes avoiding high fund fees especially important for investors. Jack Bogle, Vanguard’s founder, preaches about the tyranny of compounding, the financial devastation wrought as fees feed on themselves and cut into returns. By betting against the relentless rules of humble arithmetic, most mutual fund investors are needlessly paying 2 percent or more in fees. According to Morningstar, the average domestic stock fund has a 1.39 percent expense ratio and by my calculations, hidden fees such as transaction costs tack on another 0.75 percent annually. Funds that trade less frequently generally have lower hidden costs.

To illustrate the impact of the tyranny of compounding, consider a $10,000 investment in each of two stock funds, and assume that each will beat inflation by 4.5 percent annually, before costs. The low-cost fund charges 0.2 percent annual expenses; the other charges 2 percent. This means the low-cost portfolio will earn an average of 4.3 percent a year after inflation, while the other portfolio earns 2.5 percent. At first, it looks like the high-cost portfolio is giving up less than half the return of the low-cost portfolio (2.5 versus 4.3). Yet bad goes to worse with the tyranny of compounding. The average-cost portfolio gains $8,540 in inflation-adjusted dollars over 25 years, while the low-cost portfolio earns $18,650.

Some Good News — But Hold Your Applause

So what about the seemingly good news that two big fund companies are lowering their fees? Last month, Putnam announced it would cut fees 13 percent on its fixed-income funds and 10 percent on its asset-allocation funds. In May, Schwab lowered expense ratios (fund expenses as a percentage of assets) of its two main index funds — its S&P 500 Index fund (SWPIX) and Schwab Total Stock Market Fund (SWTIX) now have fees of only 0.09 percent annually, down from 0.36 percent and 0.53 percent respectively. Schwab’s fees now undercut those of competing funds from Fidelity, which charges 0.10 percent annually, and famously low-cost Vanguard with its 0.18 percent annual fee. (Fidelity and Vanguard have equivalent funds with similar or lower fees for $100,000 balances. Schwab’s minimum is only $100.)

Lower fees from Schwab and Putnam are great news when so many other funds have increased fees, but keep in mind these two rules when picking funds:

  • Compare the fund’s expense ratio with the competition. While Putnam may be lowering some fees, it’s still charging about five times that of Vanguard for domestic equity funds (see table below). After adjusting for asset classes, Putnam underperformed Vanguard by about 1.6 percentage points annually since 2005, or just a bit more than the fee differentials would have predicted. The performance gap may narrow a bit going forward as fee differentials have slightly decreased.
  • Look at the family’s fees. Schwab and Fidelity may now charge less for a few index funds, but these are probably loss leaders aimed to help them sell other more expensive funds. If you want to invest with Schwab or Fidelity just for their index funds, these low-cost choices are now worth a look. It’s like going to the back of the more expensive supermarket to get that gallon of milk on sale. It’s a good deal as long as you avoid buying more expensive items along the way.
Equity Funds
Average Expense
Ratio (2008)
Vanguard 0.21%
Schwab 0.70%
Fidelity 1.17%
Putnam 1.41%
Source: Morningstar

Bottom line: What do lower fund fees mean to you? They mean higher returns, which will allow you to reach your financial goals sooner. So choose an asset allocation that is right for you and then build the portfolio with low-cost diversified stock and bond funds that pay you rather than Wall Street.

Allan Roth is a financial planner who writes The Irrational Investor blog on CBS

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