Expenses Over Time

A fund with high costs must perform better than a low-cost fund to generate the same returns for your clients. Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund with a 10% annual return before expenses with annual operating expenses of 1.5%, you would have ~ $49,725 after 20 years. But if the fund had expenses of only 0.5%, you would end up with $60,858—a 22.4% difference. It takes only minutes to use a mutual fund cost calculator (see “Web Tools” at the end of this chapter) to compute how costs of different funds add up over time and eat into returns.

As a broad generality, look for domestic equity and fixed-income funds with expense ratios under 1.25%. Some advisory sources believe that equity funds should have expenses of less than 1%, and fixed-income funds should have expense ratios of 0.75% or lower. However, such a number would exclude a number of excellent offerings. Similarly, there are superior fixed-income choices from other fund families that have expense ratios just a little above 1.00%.

Certain fund categories are more expensive to operate than others. Thus, there should be a distinction between some broad fixed-income categories (e.g., investment grade, high yield, foreign, and emerging markets) and equity categories (e.g., large cap growth, small cap value, overseas, developing markets, and certain sector groups).

However, the real points are (1) expense ratios affect returns on bond funds more than their equity counterparts (since historical returns have been less for bonds)—in short, they represent a higher percentage of the total return and (2) few investors appear concerned with a fund’s expense ratio (perhaps because it is not shown on shareholder statements). Advisors should weigh the benefits of relationships they have with existing fund families, risk-adjusted returns, breadth of offerings, service, and how they are being compensated.

At the request of Congress, the General Accounting Office (GAO) studied the issue of mutual fund fees and expenses. The GAO did not reach any conclusion (meaning they did not say fees were high, low, or appropriate) but did call for greater disclosure.

Historical Perspective

In 1949, MIT, the oldest mutual fund in the U.S., had $300 million in assets and an expense ratio under 0.2%. Despite a 23-fold increase in its portfolio size, the fund’s current expense ratio is a little under 1.2%. MIT’s expense ratio is below its peer group average, but such a comparison is dramatic (a 23-fold asset increase over 60+ years, yet a 500% increase in expense ratio). One defensive argument is that competition and advertising rates have increased radically.

2000-2016 Average Asset-Weighted Expense Ratio  (%)

Although expenses have dropped ever so slightly, only five of the 20 largest fund companies are charging less on an asset-weighted basis than they were 15 years ago. On the no-load side, Vanguard remains the cheapest (0.22%) followed by Dodge & Cox (0.53%), Fidelity (0.75%), T. Rowe Price (0.80%), and Janus (0.87%). With commission funds, American Funds (0.76%) is definitely the least expensive followed by Franklin-Templeton (0.98%) and Van Kampen (1.15%).

A frequently asked question is whether the SEC imposes any specific limits on the fees a fund may charge. The short answer is the SEC generally does not; FINRA, however, does impose limits on some fees.

Morningstar Study

A July 2010 study by Morningstar shows using low fees as a guide for mutual fund selection would have given investors better results than using Morningstar’s own star-rating system. The study covered the period from 2005 through March 2010 and concluded: “Among domestic equity funds, returns of lower-cost funds outpaced returns of higher-cost funds by about 1.3 percentage points a year. Over a 50-year period, a return at the 8.1% historical average for stocks would produce nearly 50% more capital than a return of 6.8%.”

The Morningstar conclusion actually understates the benefit of using low-cost funds since its study is based on survivorship basis. According to Morningstar, only 57% of the highest-cost quintile equity funds survived the previous five years; 81% of the lowest-cost quintile survived the same period.

In 1990, fund expenses consumed 20% of equity fund dividend income, a figure similar to what funds experienced in 1960. Since 1990, as dividends decreased, expenses ate up 51% of dividends and then dropped down to 40% in 2010.