Little Things Mean a Whole Lot Where Fund Fees Are Concerned

Most of us know how much we pay each month for cable television, yet haven’t a clue how much we shell out to mutual fund companies to invest and protect our life savings.

And for the last few years, who needed to bother?

Up until the third quarter--the worst quarter for stock funds in eight years--a number of our funds had been growing in value 20% or more a year. Routinely.

Given those phenomenal returns, what did we care if mutual fund companies were skimming 1.5% to 2% off the top? Consider it a tip for a job well done.

But those days are over. The bull market is in hibernation. Investors now realize that returns of 20% are likely to be the exception, not the norm. (If they don’t, they should.)

And 2% in annual expenses sure seems like a high price to pay for a fund delivering returns of just 5% a year--or for a fund that’s losing money, as many are right now.

“The bull market of the last decade has blinded the investor to the impact of fees,” said Coral Gables, Fla., financial planner Harold Evensky, who last week testified before a House subcommittee exploring trends in mutual fund fees. “Once investors start losing money, they’ll start paying attention.”

Two things should make you pay attention right now, whether your mutual funds are making money or not:

* Point 1: Mutual fund fees can easily cost individual investors hundreds of thousands of dollars over the course of their lives.

How is that possible?

Here’s one simple yet typical example: Let’s say you’re 25 years old and put $10,000 into a fund with market returns of 12% a year. But because the fund charges 2% a year in expenses, the actual annual average return to the investor is 10%.

We’re not referring here to the front-end sales commissions, or loads, that most of you know about. We’re referring to the annual expenses that funds impose to manage your money. According to fund tracker Morningstar Inc., the typical mutual fund charges annual expenses of 1.4% to 1.5%.

By the time you turn 65, that one-time investment will have grown to $453,000. Which is kind of amazing when you think about it. But had the fund not imposed that seemingly tiny annual expense, you’d have earned a whopping $931,000 after 40 years. Which is even more amazing.

* Point 2: Mutual fund fees are a key predictor of a fund’s performance.

According to Matthew Fink, president of the Investment Company Institute, the mutual fund industry’s chief trade group, investors tend to buy funds based on their performance, level of risk and fees--in that order.

But performance has a correlation to fees. For instance, divide Morningstar’s universe of more than 3,000 domestic mutual funds into four categories--those with expense ratios of 0.5% or below, those with ratios of 0.5% to 1%, those with ratios of 1% to 2% and those with ratios of 2% or above.

What you find is an inverse relationship.

For instance, in August, when stocks pulled back violently, the group that charged the lowest expenses lost just 15.3%. Funds that imposed fees of 0.5% to 1% tumbled 16.2%. Funds with expenses of 1% to 2% fell even more--17.1%--as did the group that charged 2% or more; it fell 17.6%.

The same principle holds in rising markets too. In our example, the lowest-fee funds delivered annualized returns of 15.3% over the last 10 years, according to Morningstar. The group with slightly higher fees gained 14.7%. The group with even higher fees advanced even less--13.2%. And the group with the highest fees generated returns of just 8.9% a year.

“Expenses not only have an impact,” notes Evensky, “they have a big impact.”

So what should you do?

* Read your mutual fund prospectus to find out how much you can expect to pay in “total annual expenses.” The prospectus should spell out--in both dollar and percentage terms--exactly how much you can expect to pay based on various assumed rates of return.

* Call your fund company to find out what the fund’s actual expenses are. (You can find also find this out by going to Morningstar’s Web site--https://www.morningstar.net). If the fund is in your company-sponsored 401(k) retirement plan, call your plan administrator to get this information.

* Begin any search for mutual funds with those that charge lower-than-average expenses (and, while you’re at it, try to avoid funds that impose one-time sales commissions or loads).

If you believe ICI’s Fink, most investors are doing this already. In testimony he gave last week to the House Commerce Subcommittee on Finance and Hazardous Materials (affectionately known as the “cash and trash” subcommittee), Fink cited ICI research showing that 77% of fund investors are in funds that charge expenses below the industry average of about 1.5%.

But don’t let these statistics lull you into a false sense of accomplishment, Evensky warns.

It may sound incremental, but there’s a world of difference between shelling out 1.2% a year in expenses and handing over just 1 percentage point less.

Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.