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Why Fund Costs Are Falling

NEW YORK (TheStreet) -- Fund investors have been dumping expensive mutual funds and gravitating toward low-cost choices.

According to a recent study by the Investment Company Institute, expense ratios for the average investor in equity funds dropped from 1.0% in 2003 to 0.79% last year.

Part of the decline can be attributed to the fact that shareholders have become savvier about shopping for bargains.

But much of the change is due to an upheaval in the operations of financial advisers. Because of a big change in how they are compensated, more advisers have been steering clients toward the cheapest funds.

In the past, advisers -- who account for half of all mutual fund sales -- often made more money by selling expensive funds.

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In a typical transaction, the shareholder would pay a load, or sales commission, of 5%. When a client invested $10,000 into a fund, $500 of the total went to the adviser.

In some cases, the advisers got additional fees and incentives for selling the load funds. Many load funds had steep annual expense ratios, but that didn't discourage advisers from recommending the investments.

Advisers had big incentives to collect the up-front commissions, and less reason to worry about the costs that clients faced.

Then in recent years, the compensation system for many advisers changed.

Instead of collecting a sales commission every time a client buys a fund, advisers take flat annual fees that are typically 1% of the assets in an account.

Many advisers now recommend no-load funds, which do not charge commissions. In this new world, an adviser automatically gets paid more as a client's assets increase.

That gives the adviser a clear incentive to make the client wealthier.

To appreciate why assets have been pouring into cheap funds, consider an adviser who is comparing two similar funds for a client.

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One fund charges an annual expense ratio of 1.5%, while the other charges 0.5%. If the adviser recommends the more expensive fund, he knows that the client will pay 1 percentage point more in fees, which will disappear into the pockets of the fund company.

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