Watch Out for Annual Operating Expense Fees

Every little bit counts, as mutual fund companies well know.

Portfolio managers have a hard enough time selecting the stocks or bonds that will let them beat their rivals. If they could somehow garner a slight edge beyond actual performance, most would thank their lucky stars.

That’s where annual expenses come in.

All funds face certain operating expenses, which reflect ongoing outlays for staff, offices, equipment, shareholder services and other assistance, including the fee to hire the portfolio manager. Normally, these standard costs will eat up just 1% to 1.5% of a typical fund’s assets each year--hardly enough to get worked up about.

But for any given portfolio, operating expenses can range from under 0.5% annually to more than 3%. At extreme levels and compounded over several years, they can make or break a fund.

Investors don’t pay for annual expenses all at once. Instead, the investment company will subtract the charges gradually over the course of a year. This means a fund’s per-share price, quoted in newspapers, will already reflect them.

Don’t confuse annual expenses with sales charges. Front- or back-end loads, which can range as high as 8.5%, are one-time levies that don’t figure into the yearly expense equation. However, 12b-1 fees, a type of marketing cost that sometimes is used to compensate stockbrokers and other salesmen, does count. In fact, a relatively high 12b-1 of 1% or more can easily double a fund’s ongoing costs.

How important are annual expenses? Craig Litman of Litman/Gregory & Co., a San Francisco-based money management firm specializing in mutual funds, cites several other factors that normally weigh more heavily, including a fund’s investment approach, track record, management style and the like. “The expense ratio is not the most important item, but it can help you choose among funds when other things are equal,” he says.

Joe Mansueto, president of Morningstar Inc., a Chicago firm that tracks fund performance, points out that a bloated expense ratio wouldn’t affect all types of portfolios to the same degree. A good stock manager would have an easier time masking high ongoing costs with superior performance.

Not so with bond and money market funds, which tend to move more closely in line with one another. “Expense ratios are more critical on the fixed-income side, where annual returns tend to be more tightly clustered,” Mansueto says.

Basis-Point Battle

If you don’t think fund companies take their expenses seriously, tune into the verbal duel being waged by the Vanguard fund group against two rival giants, Dreyfus and Fidelity. The controversy erupted when Dreyfus and Fidelity decided to limit expenses on certain money-market funds, allowing them to boost their yields and lure investors.

Dreyfus pledged to absorb all operating expenses on its Worldwide Dollar Money Market Fund at least until June 15 or until the portfolio reaches $7.5 billion in assets, at which time the policy will be reviewed. Fidelity guaranteed to cap the expense ratio on its Spartan Money Market Fund at 0.45% a year--45 “basis points” in investment lingo. Compare those numbers to the 0.65% to 0.8% in annual expenses that the typical money market fund runs up.

Vanguard Chairman John C. Bogle complained to the Securities and Exchange Commission that Dreyfus and Fidelity ads touting the money funds are misleading because they incorporate the temporary fee waivers to arrive at attractive annualized yield figures. (At the time of Bogle’s complaint in late March, Fidelity’s expense cap extended through 1992 only; it has since been extended through 1995.)

Dreyfus and Fidelity deny any deceptions and point out that investors can, at any time, make penalty-free withdrawals from the funds. “The yield we advertise is the yield we pay. There’s nothing tricky about it,” says Neal Litvack, vice president of marketing for Fidelity in Boston.

While Dreyfus is itself footing the bill for annual expenses on Worldwide Dollar, Fidelity has adopted more of a pay-as-you-go approach with Spartan. To keep the fund’s costs down, it charges shareholders $2 for each check they write against their Spartan account, each wire transfer they request and every exchange of shares they make into another fund. Most money funds don’t charge separately for such transactions. But Litvack calls Spartan’s way a more equitable approach for shareholders who don’t make much use of these services.

Comparing Apples

Fortunately, expense ratios are relatively easy to find and compare. Before you invest in a fund, consult its prospectus. Standard tables near the front of the document list all fees and charges, including the expense ratio. Look for any multiyear trends that show expenses rising or, preferably, declining.

Make an effort to compare apples to apples. It would be misleading to examine the expense ratio of an international stock fund, for instance, next to that of a municipal bond portfolio. Fixed-income funds tend to have lower proportionate costs. The same goes for larger portfolios of any type because they can spread their expenses across a bigger asset base.

Keep in mind that a fund’s expense ratio won’t include transaction costs--outlays for buying and selling stocks or bonds. But another prospectus line item, the entry for “portfolio turnover,” will reflect how often a manager trades securities.

An annual turnover rate of 100% implies that every stock or bond is replaced once a year on average. A 200% rate would imply twice as much trading, at perhaps twice the cost. As with expense ratios, watch for worsening trends in portfolio turnover.

TRACKING EXPENSE RATIOS

A fund’s expense ratio, which can be found in the prospectus, expresses annual operating costs divided by total assets. It’s an important tool that can help you spot mutual funds burdened by excessive costs. Just keep in mind that you should compare a fund’s expense ratio to that of others in its investment classification. Various categories of bond funds, for example, tend to have lower expense numbers than stock portfolios, as the following table shows.

Average Fund Category: Securities Held : Expense Ratio

Specialty stock (financial) Common stock issued by companies in the financial industry: 2.14%

International stock: Stock issued by foreign firms: 1.54%

Specialty stock (precious metals) Stock issued by firms that produce gold, silver or platinum: 1.49%

Option-income: Stock issued by larger companies and options linked to those shares: 1.49%

Specialty stock (utilities) Stock issued by electric, gas, telephone and other utilities: 1.42%

International bond: Debt issued by foreign governments, agencies and corporations: 1.39%

Growth stock: Common stock: 1.37%

Government bond (general): Debt issued by the Treasury and government-backed agencies: 1.20%

Balanced: Common stock, corporate and government bonds, and cash: 1.03%

Corporate bond (high yield): Lower rated (“junk”) company debt: 1.02%

Government bond (mortgage): Debt issued by government agencies, especially in the housing sector: 0.99%

Corporate bond (high quality): Highly rated (“investment grade”) company bonds and government debt: 0.82%

Tax-free bond: Municipal bonds: 0.78%

Source: Mutual Fund Values, a publication of Morningstar Inc.