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Originally published Saturday, May 31, 2014 at 8:03 PM

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When it comes to mutual funds, be a cheapskate | Chuck Jaffe

Mutual-fund investors should only pay above-average expenses under three circumstances: You have no choice, it’s a new fund, and you can reasonably expect returns to justify oversized payments.


Syndicated columnist

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Your Funds

Mutual-fund fees, on average, fell again in 2013.

That’s good news, so long as you actually participated in it.

Most fund investors barely know where they stand.

Oh, they included expense ratio in their fund-selection criteria — and can rest easy saying their costs are “below average” — but the news about fund fees released recently in separate annual studies from both the Investment Company Institute and from Morningstar shows just how hard it is to believe that you are getting the best deal for your investment moneys.

It’s not really any big surprise that fund costs went down last year.

The stock market posted huge gains in 2013, helping funds to increase their asset size.

As funds grow, their asset size typically crosses “break points,” where the amount charged to shareholders goes down. This drops a fund’s overall costs.

It also explains why most of the expense reductions came in equities rather than bonds, where investors typically were pulling money.

That can drive a fund backward crossing the break point in reverse and raising a fund’s overall expense ratio; mostly, costs for bond and hybrid funds remained stable in 2013.

The overall trend is strong.

ICI reported that the average expense ratio investors paid last year for equity funds was 0.74 percent, a decline of 0.03 points from 2012, but down from 1.01 percent in 2007. Morningstar pegged expenses for the average investor in open-end mutual funds at 0.71 percent in 2013; it showed a peak of 0.85 percent in 2000.

But those average numbers are “asset-weighted,” meaning that they reflect where consumers are putting their money.

They are a far cry from the “average fund,” the one where the costs fall right in the middle of the fund peer group.

For example, Morningstar tracks over 1,500 large-cap growth funds and the average expense ratio for those funds is 1.22 percent.

The average asset-weighted cost for that category — the expenses paid by the typical large-cap growth investor — is 0.76 percent.

Thus, a large-cap growth fund could crow about “below-average costs” with an expense ratio of, say, 1.0 percent, even though shareholders would be paying more than the average investor in the category to own that fund.

“The number that the average shareholder pays is the better benchmark because it’s a better measure of the funds that are actually in front of the consumer, it reflects what people are paying for funds they want to own,” said Russel Kinnel, director of mutual fund research at Morningstar. “The fact that there are hundreds of obscure firms charging a lot more doesn’t matter that much.”

Fund shareholders generally assume that average stock funds charge 1.25 to 1.5 percent, with bond funds coming in between 0.75 and 1.0 percent.

Judging from the dollar-weighted numbers, typical investors pay only about 60 percent of those averages.

You should strive for at least that much savings, too.

Kinnel suggested finding the low-cost index fund and actively managed options in a category as a way to see if you want to “pay up” to own a fund.

“If a fund charges higher expense ratios than the best in its categories, let the fund talk you into why you’d be willing to pay double or triple to be in the same asset class,” Kinnel said.

“It should never be ‘This fund has awesome returns and I will be blind to everything else.’ You should only pay more for a fund if you are convinced it’s worth it,” Kinnel said.

You shouldn’t be convinced easily.

In fact, fund investors should only pay above-average expenses — using the asset-weighted numbers — under three circumstances:

1) There’s no choice. If you are in a retirement plan with only high-cost options, you can’t afford to miss out on company matching funds or tax-deferment benefits.

Hold your nose, buy the best funds available and plan to roll into a low-cost self-directed IRA the moment you change jobs or retire.

2) It’s a new fund, from a family that has a history of bringing costs down as assets grow and mature.

3) You reasonably expect returns to justify oversized payments.

Certain asset classes naturally have higher expenses — micro-cap stocks and emerging-markets funds typically have higher research costs than plain-vanilla growth funds, for example — but they diversify a portfolio and come with the promise of better returns than their more-staid peers.

While paying up for a type of asset — with the category average cost as a limit — can make sense, ponying up more for a specific manager typically doesn’t; for years, investors justified paying Legg Mason legend Bill Miller oversized fees because of his performance, a move that made sense right up to the point where they recognized that his numbers weren’t nearly as good as his reputation.

Few managers are so consistently excellent for long enough that they’re worth a significant premium.

Said Kinnel: “The less a fund manager has to overcome, the better their performance, the happier you are likely to be. ... Investors have recognized it, they just can’t allow themselves to be talked out of it.”

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com or at P.O. Box 70, Cohasset, MA 02025-0070.

Copyright 2014, MarketWatch



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