Win the fight against fat fund fees

By Tim Middleton

The cost of mutual funds is cracking and falling under the lash of prosecutor and public alike.

In recent months the nation's two largest vendors of broker-sold funds have reined in the sale of so-called B shares, the kind that are the most expensive for shareholders to own and most remunerative for salespeople to sell.

The moves were clearly influenced by the focus on high expenses that emerged in 2003's rash of fund scandals, which so far have cost the industry more than $2 billion in fines, fee cuts and disgorgement of illicit profits.

Yet more attention on expenses came last year when, goaded by competition from a new form of managed portfolio called the exchange-traded fund (ETF), Fidelity Investments slashed fees on certain of its index funds even below those of the industry's low-cost leader, Vanguard Group.

"We're seeing a lot more cuts in expense ratios than we did before," says Russel Kinnel, Morningstar's director of fund research. The biggest impetus came from demands by New York Attorney General Eliot Spitzer that funds caught in the scandal cut their costs. "But we're seeing cuts from fund companies that aren't being forced to, as well," Kinnel says.

Lower fees weren't much of an issue in the bull market of 1982-2000, but they became increasingly desirable when profits disappeared in the bear market. With low returns forecast for years to come, the pressure on vendors to cut their costs is rising further.

The worst choice

At load funds, the most abusive expenses are so-called 12b-1 fees, or indirect sales commissions. They're one-quarter of a percentage point annually on A shares and a full point on B shares. The higher annual expenses, combined with back-end sales commissions, make B shares the worst possible choice for nearly all investors.

B shares, however, pay the highest commissions to stockbrokers. Due to what are called breakpoints, or commission discounts applied to A shares but not other share classes, a purchase of $100,000 in load-fund shares would generate an average commission of $3,500 for A shares, but $5,000 for B shares.

Brokers, who also sometimes misrepresent B shares as "no-load funds" because the commission is hidden as redemption and 12b-1 charges, had great luck with B shares until the tech bubble burst in 2000. That year B shares accounted for 31.2% of all load-fund sales.

But during the bear market investors began to recognize B shares as toxic waste, and dropped them en masse. Sales of B shares balanced redemptions industry-wide in 2001, but that began to change the following year, and in 2003 redemptions outpaced sales by $18 billion, according to the Investment Company Institute.

So in recent weeks, Franklin/Templeton Funds announced it would stop selling B shares altogether. American Funds, which resisted offering B shares until 2000, said it would not allow investors to buy more than $50,000 worth of them, down from $100,000.

"Given the overall sense that this is an issue that needs to be looked at, we tried to be more conservative than we have been in the past," says Chuck Freadhoff, American's spokesman.

Selling the house brand

Both Franklin and American are independent investment firms. Stockbrokers are often encouraged to sell in-house mutual funds, even though they usually aren't as good. When it was known as Dean Witter, Morgan Stanley (MWD, news, msgs) didn't even offer A shares, but as recently as 2002 it had nearly 90% of fund assets in B shares.

Morgan Stanley last year agreed to pay $50 million to settle Securities and Exchange Commission and National Association of Securities Dealers charges centered on sales practices, including abusive B share sales. It has hemorrhaged B share assets: nearly $7.5 billion in 2002, $4.69 billion in 2003 and $7.11 billion in 2004, according to Financial Research Corp.

No-load fund investors aren't usually gouged as openly as brokers' customers, although there are exceptions. Only recently did Fidelity abandon sales loads on all of its direct-sold funds, including its sector funds. The sales commissions were vestiges of an era before Fidelity became a no-load shop.

The famed Legg Mason Value Trust (LMVTX) charges more in annual sales commissions, or 12b-1 fees (0.95%), than it does in all other fees (0.75%), including fees for managing the money. It also keeps the money itself, rather than paying it to brokers, which is the point of 12b-1 fees higher than 0.25%.

More widely, the trend at no-load funds is toward lower fees. Recently Fidelity announced huge expense reductions on index funds in its high-minimum Spartan family, down to just one-tenth of a percentage point per year. In some cases Fidelity's index funds are even cheaper to own than ETFs, which avoid shareholder-services costs of mutual funds.

Surging inflows

In their turn, ETFs have been flooded with assets. They surged to $226.21 billion at the end of last year from $65.59 billion in 2000, the first year the ICI began tracking them.

Even Vanguard Group, whose costs are rock-bottom because it's a not-for-profit company, has issued a rash of ETFs called Vipers with expenses lower than its mutual funds.

The annual management fee for Vanguard Total Stock Market Index Fund (VTSMX), a mutual fund, is 0.2%. For Vanguard Total Stock Market Vipers (VTI, news, msgs), an ETF, it's 0.15%. Fidelity Spartan Total Market Index (FSTMX), also a mutual fund, charges 0.1%.

Fidelity is a for-profit company. But the Fidelity Spartan index funds are estimated to lose $40 million annually. The company runs them as loss-leaders to attract other, more lucrative business.

But that doesn't mean you should ignore them. In investing, a penny saved is a lot more than a penny earned. Cutting 1% in annual expenses on a $10,000 fund investment adds up to an extra $2,263 over 10 years.

What to look for

Here's the cost-cut curve, from lower to lowest.

• Buy A shares (if you invest) or C shares (if you're a heavy trader).

• Buy funds from low-overhead companies, such as Vanguard, Fidelity and American Funds.

• Buy true no-load funds (no direct commissions, no 12b-1 fees greater than 0.25%).

• Buy index funds (expenses one-quarter to one-tenth as much as actively managed funds).

• Buy exchange-traded funds (expenses 25% below mutual funds).

The financial industry is clearly reacting to pressure from investors and regulators to lower costs. But you can exert pressure of the individual kind by shunning high-cost funds for cheap ones.

When you do, you'll automatically reduce the risk of investing because high-cost funds have to accept more risk to pay their higher costs. That Legg Mason fund, which has beaten the market for 14 consecutive years, is 48% riskier than the market, in terms of its standard deviation.

And as of Jan. 26, when the S&P 500 ($INX) was down 3.1% this year, the Legg Mason fund was down 5%. Risk is always dicey, except when it's terrifying.

At the time of publication, Tim Middleton owned or controlled the following securities mentioned in this article: Vanguard Total Stock Market Index Fund. He is the author of "The Bond King: Investment Secrets from PIMCO's Bill Gross." He was formerly mutual fund columnist of The New York Times and works from home in Short Hills, N.J.