Why Mutual Fund Expenses Matter

How many times have we heard a TV pitchman holler, "We deal in volume and pass the savings along to you!" Now imagine the same guy saying, "We deal in volume and pass the savings along to ... us!" That may be the secret snicker of your mutual fund company.

The question is, what are you going to do about it?

As the fund industry has swelled in the past dozen years $770 billion in assets to more than $4.5 trillion, creating huge economies of scale, average expenses charged to stock-fund investors have actually risen, from 1.28% to 1.55%. The same trend applies to bond funds, whose average expense ratio is 1.08%, versus 0.89% twelve years ago.

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Scudder Development, an aggressive-growth fund with below-average returns, generates more than $12.5 million in fees each year from its 1.52% expense ratio. The gigantic Kaufmann fund grossed $67.9 million in 1999 by paying itself 1.94% of its $3.5 billion in assets.

Higher expenses hurt fund returns

By definition, expenses nip a percentage of your mutual fund assets each year. The higher the expense ratio, the harder it is to beat market indexes or category averages.

You're probably saying, I know that, I know that.

But the extent to which returns dwindle because of higher expenses may surprise you because the expenses are deducted before the fund reports results to shareholders.

We divided the 1,100-plus long-term-growth funds into two groups: those with expense ratios above the average for the category and those with ratios below the norm. On average, those with lower expense ratios returned two percentage points a year more than funds with above-average expenses the past five years.

So if you dropped $10,000 into a higher-expense long-term-growth fund five years ago, you'd have about $1,500 less today than if you'd invested in a lower-expense fund. And if you were saving for a long-term goal--say, retirement 25 years away--you'd have 50% more at the end of that time with the lower-expense fund. (This assumes a 10% return for the high-expense fund, versus a 12% return for the low-expense fund.)

The results are the same in virtually every other fund category--the low-expense funds return more, on average, than the high-expense funds. The exception is high-quality corporate-bond funds. In that category, the high-expense funds do better.