How much does your fund really cost?

By Morningstar

I recently shelled out $200 to fix a broken window in my apartment. The building owner left a bill outlining the charges explicitly in dollars and cents, and I just tacked on the total to my rent check.

But I couldn't help but wonder how things might have been different if she operated more like a mutual fund company.

Instead of clearly outlining what I owed, she would have told me that the broken window amounted to 1.28% of my annual rent. And it would've been deducted straight from my account, so I never would have cut her a check at all. In the end, I wouldn't have had a clear idea of how much that broken window really cost me.

Though you probably know what you're paying your handyman, lawyer and accountant, most mutual fund shareholders have, at best, a foggy idea of what their investments cost them. In fact, your investment-related expenses might be among your largest annual expenses after food and shelter. You may be paying a three- or four-digit investment-management bill and be none the wiser.

Indeed, you pay fund companies every day when they take a small cut out of your account to cover their expenses. The annual tally of these costs gets expressed in percentage terms as the fund's expense ratio. The expense ratio doesn't encompass every cost borne by shareholders -- trading costs aren't included in the total -- but it at least helps make it easy to compare funds.

However, expense ratios don't show you how much you'll pay in dollar terms.

Let's say you have $100,000 invested in Oakmark (OAKMX). Oakmark's annual expense ratio is 1.05%, which translates into $1,050 a year in fees. In this instance, it's money well-spent, because Oakmark is one of the best funds going. But given the size of your expense, you would want to think twice if all you got were mediocre long-term returns.

Why investors need better information

True, the Securities and Exchange Commission already makes fund companies publish a hypothetical example of how much you'd pay in fees over the next one, three, five and 10 years if you'd made a $10,000 investment. They also show you the toll that taxes would have exacted on your return if you had held the fund in a taxable account.

But fund companies should go further, spelling out the actual dollar amount each shareholder paid in expenses in the account statements.

Doing so wouldn't force fund companies to perform any calculations that they're not doing already. After all, they have to figure out how much to charge each shareholder now. The difference is that investors would get to see the numbers, too.

It's not as if this is a pipe dream. In fact, mutual fund company MFS provides a tool on its Web site that allows its shareholders to view the actual dollar costs of the fees they pay. If other fund companies disclosed to shareholders the actual costs they were charged, they would be much more attuned to the price they're paying for investment management.

Making investors more aware of cost could, in turn, inject another much-needed dose of price competition to the fund industry. Although fund fees have fallen modestly in recent years, that's only after more than a decade of going virtually nowhere despite an explosion in assets.

• Video: Foreign investing is for everyone

Competition in the industry is somewhat limited because tax and commission costs can make it expensive to switch from one fund to another, but the more price-conscious investors there are, the lower fund expenses are likely to be. That's certainly been the experience elsewhere -- witness the falling costs in price-competitive industries ranging from computers to airlines.

Penny-wise but pound-foolish?

Critics of our proposal might worry that investors will come to resemble Oscar Wilde's description of a cynic, who knows the price of everything but the value of nothing. Wrongheaded investors might dump a worthwhile investment simply from sticker shock. But if consumers are smart enough to farm out their accounting or legal work to professionals even though they'll end up footing the bill, they should be willing to open their pocketbooks for professional money management if they need it.

The fund industry likely will carp about the expense of providing customized statements on ownership costs. But I'd argue that most shareholders would be willing to pay a modestly higher fee if it meant they'd know better what they're paying. And if more transparency brings down expenses across the industry, that might offset any additional cost.

In the end, investors need to be equipped to make well-informed decisions on the basis of price, because it's so crucial. Fund expenses are among the best predictors of long-term success, after all. With more clarity on costs, we think investors can make better choices.

This article was reported and written by Christopher Davis for Morningstar.