Fund Fees Decline... Sort Of

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The mutual fund industry says it has some good news: expense ratios and other costs have come down dramatically over the years.

There’s no reason to doubt this week’s new number from the Investment Company Institute, the fund industry’s trade group. But the ICI, which issues a fee report every year at this time, has taken the rosiest view it can, as it usually does.

Since 1990, the ICI says, “the average fees and expenses paid by mutual fund investors have fallen by half.” Way back then the average investor paid 198 basis points, or 1.98% a year. Now the number is 99 basis points, or 0.99%. The number held steady between 2008 and 2009.

But notice that qualifier: “paid by investors.” The ICI calculation uses a system that gives more weight to funds with more total assets. If you had one fund charging 200 basis points and one charging 50, you might say the average expense ratio was 125 basis points, figured by adding 200 to 50 and dividing by two.

But suppose the 50 basis point fund had five times the assets of the other fund. By looking at the total expenses paid by investors in the two funds as a percentage of total assets, you’d come up with an average expense ratio of 75 basis points, a lot less than 125. That’s how the ICI looks at it.

The ICI’s approach is perfectly accurate, and really does reflect what investors pay. But the casual observer might misunderstand the figures, thinking they means the fund industry has slashed its expenses over the years. In fact, there has not been a dramatic cut in the expenses funds charge. The falling figure is the result of investors’ growing preference for funds with lower fees.

A big factor is investors' growing use of index-style funds that charge rock-bottom expenses — less than 20 basis points, or 0.2%, in many cases. Also, do-it-yourself investors steer clear of “loads,” which are a form of commission charged by brokers and other financial advisers. Loads are included in the ICI’s calculations.

Critics have been arguing for years that as fund-industry assets grow, normal economies of scale should drive fund expenses lower than they have. The problem is that most fund companies are for-profit businesses. They resist fee reductions because that’s where they make their money. The big exception is Vanguard Group, which is owned by the people who invest in Vanguard funds. Vanguard is known for its low costs, though some for-profit fund families, such as Fidelity Investments, now have some dirt-cheap funds as well.

Fees that look small can do lots of damage over time. If you put $10,000 into a fund charging 0.2% and the fund’s holdings returned 8% a year, you’d have $44,900 after 20 years. If expenses were 1%, you’d end up with $39,000. The lower fee would leave you with 15% more.

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