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Archive for Tuesday, June 27, 2006

What’s really behind ‘lower’ mutual fund costs

June 27, 2006

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Hypocrisy alert: The mutual-fund industry is grabbing credit it doesn't deserve - again.

The industry's trade group, the Investment Company Institute, recently sent out a press release titled "Mutual Fund Costs Continued to Decline in 2005."

"The cost of owning mutual-fund shares fell again last year, to the lowest levels in more than 25 years," the statement began.

There's no reason to question the ICI's annual study - only the self-serving spin it always puts on the results. What the ICI actually found is not that so many funds are charging lower fees, but that investors are choosing the ones that do.

In other words, many investors have outsmarted fund companies that are trying to gouge them with high fees - hardly something for the industry to brag about. Fees pay for things such as salaries for fund managers and staff, plus fund-company profits. The ICI figures also include "loads," which are sales commissions charged by stock brokers.

The average stock fund carries an expense ratio, or total annual fees, of 1.53 percent - $1.53 for every $100 one has invested, the ICI said. That's figured by adding all the funds' expense ratios and dividing by the number of funds.

But the average stock fund investor pays just 0.91 percent, or 91 cents per $100. This is figured by looking at the amount of money investors have put into each fund. Total fees investors pay are divided by the total they have invested.

Investors have saved money by emphasizing funds with lower fees. So they deserve the credit, not the industry.

The ICI found investors have done the same with bond and money-market funds with below-average fees, though the results are less dramatic.

All this raises an important question: If fund companies can do perfectly well selling low-cost funds, why do they continue to sell ones with excessive fees?

Because there are always some suckers who will fall for the line, "You get what you pay for."

Investors who buy funds through stock brokers often pay loads, which in theory pay for the professionals' investment advice. But a broker who steers you to a load fund is charging for bad advice. There always are numerous no-load alternatives to any fund that charges a commission.

Certainly, it's good that the average stock-fund investor is paying 0.91 percent rather than 1.53 percent. But many of the funds with the lowest costs charge only 0.2 percent or less, so it looks like too many investors continue to pay more than they have to.

These numbers look small but add up. Imagine you invest $10,000 in each of two funds that earn 8 percent a year before fees are deducted, and that you let the investment grow for 30 years - typical for a 30- or 40-year-old investing for retirement.

After paying 0.91 percent in annual fees, one fund would grow to about $78,000. But the one charging 0.2 percent would grow to about $95,000 - nearly 22 percent more.

To get rock-bottom fees, you have to invest in index-style funds that simply duplicate broad market gauges, such as the Standard & Poor's 500. Because they simply buy and hold the stocks in the underlying index, these funds don't have to pay all those expensive stock pickers.

Anyone who tries to peddle a high-fee fund undoubtedly will argue that professional managers will more than make up for the big expenses by picking winners. But many studies have shown that few managers can beat the indexers consistently, year after year.

And even if some do, how would you know that you're choosing the ones who do it through skill rather than luck - which could change?

With its annual fund-fee report, the ICI acknowledges the benefits of minimizing fees. Unfortunately, the report implicitly shows that too many fund companies continue to charge too much.

- Jeff Brown is a business columnist for The Philadelphia Inquirer.

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