There’s a New Player in the Low-Fee Game

USAA Investment Management Co. has picked up the gauntlet thrown down by Vanguard Group.

For years, Valley Forge, Pa.-based Vanguard has been goading its competitors to cut costs on their mutual funds in light of the industry’s rising asset totals. Vanguard Chairman John Bogle has accused his rivals of failing to pass along economies of scale to shareholders.

San Antonio-based USAA has risen to the challenge with the recent introduction of a mutual fund that appears to beat a rival Vanguard portfolio at its own cost-cutting game.

USAA’s S&P; 500 Index Fund, which targets the popular Standard & Poor’s 500 index, does its job at a cost to shareholders of just 0.18% a year, equivalent to $18 for a $10,000 investment.

That’s a hair cheaper than Vanguard’s giant Index Trust 500, which charges 0.20% annually. The Vanguard portfolio, which also targets the S&P; 500, debuted in 1976 and now counts $23 billion in assets, making it larger than USAA’s entire lineup of funds.

USAA’s portfolio appears to be the most penny-pinching S&P; index fund around, according to figures compiled by Lipper Analytical Services of Summit, N.J. The Michigan-based Woodward Equity Index Fund previously held that distinction but recently raised its fees.

Mutual fund expenses come directly out of investment returns, so it’s desirable to own low-cost portfolios. Index funds are cheap to run because they merely hold the same stocks as those contained in a popular gauge such as the S&P; 500, eliminating research outlays.

The average S&P; 500 index fund charges 0.53% yearly in expenses, less than half that of the typical stock portfolio, Lipper says.

Largely because of their low costs and broad diversification, index funds make solid core holdings, many financial advisors say.

USAA sensed a demand among its shareholders for an index product but felt it needed to offer a portfolio competitive with Vanguard’s.

“With an index fund, the risk is that you won’t match the market’s returns,” said Michael J.C. Roth, president of USAA Investment Management. “That being the case, you’re best off behaving like the market by having the lowest expense ratio.”

USAA’s move is drawing skepticism from Vanguard. Spokesman Brian Mattes called the 0.18% level a ploy and predicts it won’t last.

“We can’t lower our expense ratio any further,” Mattes said. “You can’t run it for less than” 0.20%.

Vanguard Index Trust 500 has a natural cost advantage over USAA’s product because it’s a bigger fund, which means its fixed costs can be spread across a broader asset base, Mattes said.

But Roth said USAA has no plans to increase expenses on its S&P; 500 Index Fund. He concedes, however, that the portfolio, which counts $73 million in assets, remains below its break-even level of about $250 million.

USAA has adopted a couple of Vanguard tricks to help keep its expense ratio down. For starters, it requires $3,000 to open a regular account in the fund, the same as Vanguard’s threshold. As fund minimums go, both are on the high side, allowing the firms to shut out the smallest investors, who are proportionately costly to service.

Investors can buy in for less at both firms when opening individual retirement accounts.

Also, USAA imposes a $10 yearly maintenance fee on all accounts, while Vanguard charges $10 annually on balances of less than $10,000. These costs are not included in either fund’s “expense ratio,” which measures expenses divided by fund assets.

If they were, expenses would rise noticeably, at least for smaller shareholders. For example, a 0.18% expense ratio works out to $5.40 a year for someone investing the $3,000 minimum, compared with $10 for the account maintenance charge.

Nevertheless, USAA’s index fund represents a notable case of fee slashing in the mutual fund arena and signals that there’s a new low-cost competitor in town.

*

Strong Funds of Milwaukee ([800] 368-1030) is waiving all expenses on its Municipal Advantage Fund through year-end. The portfolio invests in short-term, tax-free IOUs. Waiving expenses helps boost its tax-free yield, currently running at 4.8%. When normal expenses resume, they could go as high as 0.73% annually.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

At a Glance:

USAA S&P; 500

Index Fund

* Objective: Invests in the same stocks found in Standard & Poor’s 500 index. Largest holdings include General Electric, Coca-Cola and AT&T.;

* Costs: No sales charge (no load). Annual expenses of 0.18% a year, plus a $10 account maintenance fee

* Phone: (800) 382-8722

* Minimum investment: $3,000 (regular accounts), $2,000 (IRAs)