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Mutual fund fees are falling, investors smiling

Created: 05/25/2014 1:26 PM
By: STAN CHOE

NEW YORK (AP) — Good news for investors: We're keeping more of what's ours.

Mutual funds charged less to cover operational expenses last year, as a percentage of their total assets. It was the fourth straight year that the average expense ratio fell for stock mutual funds, according to separate reports from the Investment Company Institute and Morningstar. And it's not just stocks that have become cheaper for investors to own. Expense ratios have also dropped for bond and money-market mutual funds in recent years.

It's a win for investors because they get to keep more of their returns, and funds with low expenses have historically performed better than higher-cost rivals, says Russel Kinnel, director of manager research at Morningstar. That's because low-cost funds essentially have a head start in the race for returns: High-cost funds need to make more just to match the performance of their competitors once expenses are taken into account.

It may seem like no fun to parse expense-ratio data when the difference from one fund to the next may be less than a quarter of a percentage point. "But it's something, and that advantage compounds over time and adds up to something meaningful," Kinnel says. Low costs are such a good predictor of success that Kinnel suggests investors look at a fund's expense ratio first when considering whether to purchase it.

Stock mutual funds had an average expense ratio of 0.74 percent last year, according to the Investment Company Institute. That means for every $10,000 in assets, a stock fund took $74 to cover expenses. That's down from $77 in 2012 and $100 a decade earlier. The expense ratio covers everything from analysts' salaries to the cost of mailing shareholder reports.

The expense ratio does not include every type of fee that an investor may pay. Some mutual funds charge a fee to investors when they purchase or sell shares, for example. It's called a "load" payment. These have also dropped in recent years: Average load fees paid by investors are down nearly 75 percent since 1990, according to the Investment Company Institute.

A big reason for last year's drop in expense ratios was how well the stock market performed. The Standard & Poor's 500 index returned 32.4 percent, including dividends, for its best year since 1997. The surging prices meant mutual funds suddenly had more assets. That gave funds a larger base over which to spread their expenses, many of which are fixed. Funds typically have policies that dictate they'll charge a lower fee rate once their total assets top a certain threshold.

Of course, the opposite can also happen. When stock prices fall, mutual funds find themselves with reduced assets, meaning their expense ratios will rise. That's what happened in 2009, when the stock market bottomed after the financial crisis, and the average expense ratio for stock funds rose to 0.87 percent from 0.83 percent.

All of this has helped build a greater appreciation among investors for keeping costs low. Of every $1 in net investment that flowed into mutual funds last year, 95 cents went into funds that were ranked in the bottom fifth of their category by cost. Compare that to 2001, when only 11 cents went to the cheapest funds, according to Morningstar.

Much of the drive toward low-cost funds is due to the growing popularity of index mutual funds. Instead of trying to beat the S&P 500 or another index, these funds try to merely match it. And they charge lower fees accordingly. The Vanguard Total International Stock Index fund (VGTSX) attracted $17.9 billion in net investment last year, for example, more than any other stock fund. It has an expense ratio of 0.22 percent, which Vanguard says is 82 percent lower than similar funds.

For bond funds, the average expense ratio was 0.61 percent last year. That's flat from a year ago but down from 0.75 percent a decade earlier. Money-market funds saw their average expense ratio fall to 0.17 percent last year from 0.18 percent in 2012 and 0.42 percent in 2003.

Low expenses are particularly advantageous for bond funds given how low yields have dropped. Bond investors are getting relatively little interest income, but lower fees mean they can keep a larger portion of that. The 10-year Treasury note has a yield of 2.55 percent, for example. That's down from 3.36 percent five years ago and 4.76 percent a decade ago.

Bond funds with higher expense ratios could buy bonds with bigger yields, such as junk bonds, to compensate. But those carry a higher risk of default.

To be sure, not every corner of the market is seeing a similar trend. Specialized mutual funds tend to carry higher expense ratios. In the search for steadier or better returns, some funds "short" stocks, for example. That lets them profit when a stock's price falls. Other alternative mutual funds invest in futures or commodities, which can be expensive to do.

The Investment Company Institute includes such alternative funds in its "hybrid" category. It's the only group that saw its average expense ratio rise last year -- up to 0.80 percent from 0.79 percent a year earlier.

(Copyright 2014 by The Associated Press. All Rights Reserved.)

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