Are Expenses Justified, or Just Plain Excessive?

There are lies, damn lies and mutual fund fee statistics.

Few topics provoke so much debate--or are open to so much interpretation--as the question of whether the expenses that funds charge their shareholders are reasonable.

As long as stocks are rising, investors will generally forgive even the highest fees. But if a period of flat returns sets in, fees may become a key determinant of performance and investors may not be so tolerant.

Those who have no quarrel with current fee levels argue that mutual funds are a great deal for investors and that all the carping over fee levels either misses the point or is unjustified.

Critics say expenses should be lower than they are, given the flood of money that has poured into the industry in the last several years.

John Bogle, senior chairman of the Vanguard Group, fired the first shot in this skirmish a few years ago with some well-publicized complaints that fund expense ratios had been rising over the previous few years even as assets under management were surging. The implication was that fund companies were not passing along savings achieved through economies of scale. Bogle said fund company greed was largely to blame, and he made special mention of 12b-1 fees--the ongoing levy introduced in the early ‘80s to cover fund marketing charges. Roughly half of all funds charge 12b-1 fees.

In a study last year, fund tracker Morningstar found a trend toward rising management charges among a broad mix of funds that invest in U.S. stocks, even after stripping away 12b-1 fees and other charges.

According to Morningstar, management fees on newly issued funds are about 0.2 percentage points, or 40%, higher today than they were for newly issued funds in the 1940s.

Many fund company executives point out, however, that expenses today also pay for more services than investors used to receive, which makes a direct comparison difficult. These include toll-free telephone numbers, longer service hours, retirement plans, free switching among funds in the same family, services available through the Internet and more.

“You have to look at both sides of the equation and ask how much shareholders are paying and what they’re receiving,” says William Lyons, president and chief operating officer of American Century Investments in Kansas City, Mo.

Lipper Analytical Services, an investment-performance monitoring firm, recently weighed in on the topic with a study it says shows that the fees shareholders pay are reasonable, and explaining why the average expenses of mutual funds have not declined over the last 10 years, as many people would have expected. Among Lipper’s key points:

* There are more funds today, and thus a higher proportion of funds are newer funds. Lipper counted 10,483 funds at the end of 1996, compared with 1,505 a decade earlier. Many of these new funds have not yet reached sufficient size to enjoy economies of scale. (The above tallies, incidentally, count different share classes as separate funds.) Established large funds, which make up a smaller portion of the industry now, generally have held costs stable or have lowered them over time.

* There are more international funds. The number of stock and bond funds investing in foreign securities increased to 13.4% of the industry’s total last year, from 5.9% in 1986. Foreign funds are naturally more costly to operate because of travel and other expenses associated with investing overseas.

* Money market funds, which are cheaper to operate and thus charge lower fees, also account for a smaller proportion of the industry--13.8% of the industry’s total last year, down from 22.3% in 1986.

* There are relatively fewer no-load funds. These funds fell to 33.8% of the industry’s total in 1996, from 50.4% in 1986.

Lipper predicts that average fund expenses will decline when the rate at which new funds are being created slows. In the meantime, the company says, mutual funds remain “an excellent deal for investors” compared with alternatives such as individual stocks and bonds, wrap accounts, hedge funds and certificates of deposit.

A few observers suggest that all this attention on expense figures is misplaced.

“The trouble with all this emphasis on expenses and the studies is that they are irrelevant for equity funds,” writes Walter Frank, chief investment officer at Moneyletter, a Baltimore publication.

For investors, Frank argues, it’s performance and risk that matter, and expenses are only a small part of performance.

Besides, expenses have already been figured into the fund performance numbers that are published.

Frank acknowledges, though, that expenses do matter much more for fixed-income funds.

“If anything, better performance [goes] along with higher, not lower, expenses” on stock funds, Frank says.

Peter Di Teresa, a stock fund analyst at Morningstar, doesn’t see it that way.

“The short answer is that expenses do matter,” he says. “And in the broadest sense, lower-expense [stock] funds typically do fare better,” especially over longer periods.

Then there’s the issue of predictability. Compared with a fund’s performance and its risk, each of which can vary a lot over time, expenses tend to be fairly stable. Low-cost funds tend not to become expensive overnight, and high-cost funds typically don’t slash their fees.

That’s why costs remain an important factor to most investors, especially when selecting among funds that are fairly comparable otherwise.

“To fill a particular slot in my portfolio, I wouldn’t necessarily screen out high-expense funds,” says Di Teresa. “But I’d expect a lot more from them.”

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Russ Wiles is a mutual fund columnist for The Times. He can be reached at russ.wiles@pni.com