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The Impact of Fees on Investment Returns

NEW YORK (TheStreet) -- You stroll into a local dealership, point to the latest very-fast, very-red model and announce, "I'll take that one!" You think you've done all the research: memorized the redline, can recite its 0-to-60 time, and know the turn radius by heart.

But you have no idea what the car costs. And without bothering to ask, you plunk down a credit card, confident that the ride you'll get will be well worth anything the company chooses to charge.

No way, you say? Yet that's exactly what most of us do when we buy a mutual fund. Well-schooled in the ins and outs of investments (at least the return part of the equation!), we can read risk/reward profiles like nobody's business, and account down to the penny the amount our brokers bill for stock trades. But few of us pay attention to what we pay for our funds.

No wonder. There is little that is more confusing than the rules governing this upside-down industry. In the real world, competition means lower costs to consumers. Not here. The number of new funds is growing exponentially, but fees are up, too. Any link between pay and performance? Few and far between.

The norm, instead, is that the worse you perform, the more you charge. What about a simple sticker that tells you exactly what the product costs? Uh-uh. With a jargon-packed alphabet soup of share classes, it's hard to know exactly what you will wind up paying. And even if you avoid loads and obscene expense ratios, you can still get hit with a charge AFTER you sell. Alice, welcome to Wonderland.

Figuring out the price tag of your mutual fund isn't impossible, though, so let's get down to basics.

The Load

First, check for the most overt of the charges: a load. That's a transaction-based fee paid to an investment broker or adviser when you invest in the fund -- essentially a sales commission. As high as 8 1/2% but usually ranging from 2%-5%, loads can take a big bite out of your returns. If you set aside $10,000 to invest in a fund with a 4.5% load, $450 gets skimmed right off the top; only the remaining $9,550 goes to work for you.

When you consider compounding, that really adds up. At the end of 10 years, assuming a 10% annual return, that 4.5% load costs you nearly $1200!

I prefer no-load funds, but don't rule out loads. Some of the best managers in the business work for load funds. Also, depending on your investment skill and expertise, you may need an adviser's or broker's help choosing funds. Ask him or her what asset class you're buying. They range quite literally from A to Z. A shares generally carry a front-end load. B has a back-end load (you pay at the end based on how long you held the fund) with a higher expense ratio than A. C shares often have higher 12b-1 fees, but no up-front or back-end charges.

Do-it-yourselfers, however, can find plenty of great funds that don't hit you with this granddaddy of mutual fund fees.

Expense Ratio

Trouble is that most mutual fund consumers stop with loads when it comes to expenses. We pat ourselves on the back for saving money and blithely ignore what can be an even greater drag on our investments: management and other fees. In my mind, the debate is not load or no, but high expenses or low. A hefty expense ratio can mean a lot more damage to the long-term investor than an up-front load.

All funds -- both load and no-load -- have an expense ratio. It is spelled out in the expense table of the prospectus (the topic of my column next week), where you'll find what the fund charges its shareholders to run a fund (the percentage of a fund's assets deducted every fiscal year for operating expenses). The main component is the management fee, which pays for the basics of business: manager salaries, research, overhead.

The expense ratio also includes 12b-1 fees (used to pay for marketing and distribution -- more on these particularly troublesome fees next week), administrative fees and other asset-based costs incurred by the fund. It does not reflect sales and redemption loads, or brokerage fees and other direct trading costs.

These fees, which range from less than 0.5% to more than 3%, can be quite significant. I asked Vern Hayden, a certified financial planner at the American Planning Group, to crank out the numbers with his trusty spreadsheet.

Assume you put $10,000 into three funds for ten years, and each earns 10% a year. That investment would grow to $25,426 in a fund with a 0.5% expense ratio; to $24,891 in a fund that hits you up for 1% a year; and to just $23,747 in a fund charging 2% in expenses. As you can see, you wind up with a lot less in your pocket at the end of a decade with the fund packing the higher expense ratio ($1679 less by going with Fund C rather than Fund A!).

Fund Exp. Ratio Expenses Over 10 Years You Get
Fund A 0.5% $511 $25,426
Fund B 1.0% $1,046 $24,891
Fund C 2.0% $2,189 $23,747

There it is -- in black and white (or green!) -- the reason you need to care about fees.

The average expense ratio for equity funds is 1.44%, but fees can vary dramatically by fund objective. (They also tend to run in the family: from the 0.35% dirt-cheap average of index leader Vanguard, to the up-there 2.32% of Govett, you can usually expect a fund company to show some pattern on pricing.)

When choosing a fund, I always look to see whether it has fees equal to or less than the average for funds of its type. Here's a list of the averages for the specific fund classes, so you can check how your funds compare with their peers.

Fund Type Avg. Exp. Ratio
Balanced 1.33%
Emerging Market 2.08%
European Region 1.75%
Growth 1.52%
Growth & Income 1.29%
Global Small-Cap 2.08%
International Small-Cap 1.77%
Micro-Cap 1.65%
Mid-Cap 1.48%
Natural Resources 1.75%
Small-Cap 1.47%
S&P Index 0.52%
Source: Lipper Analytical Services

One word of warning: If you have a relatively new fund, its low expense ratio may not be "real." Fund companies often absorb some of the fund's expenses in the beginning. Like the teaser rate on a credit card, you often find the higher rate is phased in later -- right when you're not looking!

Redemption, Maintenance and Performance Fees

I hate to say this, but that's not the end of the story as far as fees are concerned. You have to watch out for redemption fees. Designed to discourage short-term trading, these fees generally decrease over time and, if you hold long enough, disappear.

And there's the whole issue of maintenance fees, sometimes charged on smaller accounts. This is problematic because if you make a minimum investment and the fund loses money, you can get charged a yearly fee -- even though you dipped below the minimum because your fund performed poorly! (Remember what I said about Wonderland?)

There is one bright spot in all of this: performance fees. For each percentage point difference between the fund's investment performance and the record of the index or benchmark, the fund gains or loses fees expressed as an annual percentage of average net assets. Behemoth Vanguard and tiny Bridgeway Capital Management in Houston have been pioneers in tying pay and performance, but unfortunately, these two don't yet have much company.

What does all this mean? Should you only target expenses when buying a fund? Of course not. Fees should be on your list of things to check, but you have to consider them in context. Sometimes you get what you pay for.

The (KAUFX) Kaufmann fund, for example, charges an expense ratio of 1.93% a year, but this No. 1 growth fund has also delivered 26% annually for the past decade. Most of the time, lower-cost funds are the way to go, but don't necessarily screen out high-expense funds. Just expect more from them.

Just When You Think You're Done

One last thing -- now that you've finally figured out what you're paying for your fund, know that expenses are not static. They can change. And if recent history is any guide, they will! The expense ratio you find in the prospectus is for the past, not necessarily the future.

Fund companies can raise or lower expenses anytime their less-than-active board of directors agrees to pass along a proxy vote to shareholders.

It wasn't supposed to work that way. We were supposed to spend less time (and money) on mutual fund expenses. The logic is that as assets grow, you can spread the cost of running a portfolio over a larger asset base. But new money has flooded the industry -- and our fees just keep going up. So long as the bull keeps running, I doubt that we'll see a reversal in this trend any time soon. And so long as Wall Street looks like Pamplona, chances are investors aren't going to worry much about this.

Still, costs remain the one fairly predictable part of a mutual fund. You definitely can't guarantee that your fund will keep racking up the same returns, keep its management, or maintain a set level of volatility. But you can know with a reasonable degree of certainty what you will pay. Fees really are key to future returns.

And not knowing the cost of your fund really is like buying a car without knowing its price. This vehicle will be a lot more important to your future, however, than that fast one you're eyeing at the dealership.

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