Fund Expenses May Fall, But Only if the Market Does

WASHINGTON--Mutual fund companies are thinking a lot about expenses these days. But don't expect thoughts to turn to action, at least not until there's a major market downturn.

The average expense ratio has actually risen from 1.39% at the end of 1987 to 1.52% now, according to Morningstar data. Three fund company executives here today didn't dispute the fact that they're charging investors more to manage their money. Instead, they defended the fee increases during a panel discussion at an annual meeting of the Investment Company Institute, the mutual fund trade group.

Bridget Macaskill, president and chief executive officer of Oppenheimer Funds, said the total expenses have risen about 11 basis points (0.11%) over the last 10 years. However, she said fund companies are providing investors with more education, information, Internet and telephone access--all of which have required more money to come out of the pockets of fund companies.

"Really," she said, "they (investors) haven't paid for that."

Another reason why fund companies have no incentive to decrease fees came from panelist Mickey Roth, president chief executive officer of USAA Investment Management Company in San Antonio. "Do funds compete on cost?" he asks. "Generally, the answer to that is 'No.'"

"There are lots of physics to these fees," said Gunnar Hughes, a spokesman for Kansas City-based American Century Investments, after the panel discussion.

Indeed, there are plenty of ways to slice and dice expense ratios, as it is easy to make any statistic fit any agenda. Money market funds, for example, often cut or waive their fees just to get higher yields and attract assets. Even there, though, the fee cuts are temporary.

But when the market falls, mutual fund companies will be forced to pay more attention to their high fees. As Macaskill said, "What really matters to the investor is the return on investment after expenses." And, she said, "if returns are lower (overall), then it (fees) will matter more."

"With a market that's up 30%, 125-150 basis points doesn't really mean much," says David Brady, manager of Stein Roe's new Large Cap fund, and co-manager of Stein Roe Young Investors Fund. "But in a flat market, or a down year, it's going to make a big difference."

That could come soon. Earlier in the session, all three executives warned that the market would not continue in the roaring fashion it has run for the past three years. "The market will retrench in a way that will be a bit hurftul," predicted James Riepe, vice chairman of T. Rowe Price Associates of Baltimore.

As soon as the session ended, Vanguard Group was on a mission to dispel the panel's laissez faire attitude about increased fees charged to shareholders. The firm has built its business on low fees and index funds, growing to the second-largest fund group in the U.S.

"Fees do matter," says Brian Mattes, a spokesman with Vanguard Group. The difference of 1.0%, or 100 basis points, for a $10,000 investment over 40 years, he said, can mean as much as $4 million in an investor's pocket.

On Friday, the Securities and Exchange Commission's leader, Arthur Levitt Jr., is expected to discuss expense ratios, but it has not been determined whether he will side with the industry or investors.

--Kathryn Haines is the editor of Morningstar.Net's news team. You can reach her at khaines@mstar.com

Questions:

1. The average expense ratio has risen, according to the article, from 1.39% to 1.52%. What implications, if any, does this have for the likelihood that actively managed funds will beat the S&P 500 index fund?
2. The article makes the argument that investors are much more likely to be forgiving of high expense ratios when the market is going up strongly. Do you agree?
3. Many of these funds also have initial loads that you have to pay when you buy into the fund. What is the difference, in terms of effects of returns, of a load charge and the expenses that this article talks about?
4. If you buy a fund with a 5% load and 1.5% expense ratio, how much would it have to outperform the market by (assuming that the market will be up, on average, 12% a year) to break even? (Your time horizon is 3 years)