Insult to Injury: High-Cost Funds With Low-Rent Returns

You don't always get what you pay for. Sometimes, you get less.
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The average mutual fund levies a charge of 1.5% of your investment annually to cover its expenses and operating costs. Imagine a fund that charges triple or even 10 times that amount. The returns would have to be nothing short of amazing to make those costs worthwhile, right?

We took a look at a handful of funds with annual expense ratios ranging from 5.85% to a whopping 22.57% to determine whether the returns were worth the high fees. In general, they weren't. The high fees tended to be more of a symptom of a fund's deteriorating asset base than of a manager's stock-picking acumen.

In 1998, a year in which the

S&P 500

rose 28.7%, some of these funds actually posted

negative

returns. In other words, they lost money and charged investors premium prices for doing so. Here's a look at some of the worst offenders. A fund's expense ratio, by the way, includes 12b-1 marketing fees, management and administrative fees and operating costs. The ratio is derived by dividing these costs by total assets held in the fund. Sales charges, or loads, are not included in the ratio. That can be an additional expense.

American Heritage: One-Stock Blunder

For funds with high expense ratios and low returns, perhaps none was so egregious as the $6 million

(AHERX)

American Heritage fund, which charged a hefty 5.85% total expense ratio to shrink the size of its investors' fortunes by 61.2% in 1998. A consolation: American Heritage is a no-load fund.

Particularly suprising is that it was the No. 1 fund of 1997 when it returned 75%. But its performance suffered this year at the hands of a product that actually skyrocketed: Viagra. The problem? American Heritage didn't hold any

Pfizer

(PFE) - Get Report

, the company that makes America's favorite little blue pill. Instead, it sank a huge chunk of its assets -- as much as 75% at times -- into a competitor, U.K.-based

Senetek

(SNTKY)

. Senetek makes Invicorp, an injectible remedy for erectile dysfunction, which has proven much less popular than Viagra for obvious reasons.

Invicorp is aimed at men for whom Viagra has been ineffective, says American Heritage manager Heiko H. Thieme. With Pfizer's rise, Senetek could ride the same wave, he believed. But he is not oblivious to Invicorp's marketing challenges.

"You and I would shiver," he says at the thought of the therapy. "My God, if you say you have to stick a needle in your penis? For goodness sake, never. But I'm told it's not painful. Some people say it's not painful at all. Some say it's about like a mosquito bite."

Hmmm. In the mood yet?

Senetek stock fell 66.9% in 1998, according to

Baseline

, taking American Heritage with it. If you put $10,000 into the fund on Dec. 31, 1997, you'd now have $3,878. But you couldn't blame it all on Senetek's demise. A chunk of the money you lost would have been paid directly to

American Heritage Management

, adviser to the fund.

Here, a further word about the expense ratio should be added. Because it can be calculated daily and is based on the net assets of the fund at the time, you can't assume that a 5.85% expense ratio automatically means you paid $585 of your $10,000 investment to American Heritage. Because negative returns shrank the size of your investment, you may have paid less than that.

Thieme defends his fund's high expense ratio, saying the mutual fund business has fixed costs, such as the hiring of accountants and lawyers. For smaller funds, these costs are spread out over fewer investors.

Fidelity's

$76.3 billion

(FMAGX) - Get Report

Magellan, the world's largest mutual fund, has a total expense ratio of 0.61%.

"To run a fund that is infinitely smaller, we

still spend a few hundred thousand dollars," Thieme says. With $6 million in assets, American Heritage's expense ratio income comes to about $351,000 on an annual basis.

But considering the fund's high concentration in Senetek, you probably could have simply invested in the stock and lost the money yourself for no extra charge.

Frontier Equity: Small and Shrinking

But while American Heritage went from being tops in 1997 to being a gravedigger in 1998, another fund flung perhaps a more stinging insult at its investors.

The Frontier Equity fund posted a negative 34.2% load-adjusted return in 1998, according to Lipper. Besides have a whopping 8% front-end load -- without which the fund would have only lost 28.5% -- Frontier Equity also has a 20.72% expense ratio.

James R. Fay, the fund's manager, pleads smallness.

"Our asset size is about $360,000 at present time, and it cost about $100,000 to operate the fund for one year," Fay says. "It's the problem of being a very small mutual fund. The bigger you are, the lower that expense

ratio gets."

Fay says his fund once stood at $1.7 million in assets, but that was before the small-cap market, to which his fund is 100% committed, went horribly south. And he says the fund's high sales charge is in place to encourage brokers to sell it.

"Funds are sold, they're not bought," Fay says. "We want to put an incentive in there to go out and sell our fund."

But that sales charge does hurt shareholders. Instead of only shrinking a $10,000 investment to $7,147 without the load, the fund ate enough assets to lessen the shareholder's fortune to $6,575, according to Lipper. And don't forget, a good portion of that demise surely can be attributed to the fund's huge expense ratio.

Ameritor Funds: High-Priced Returns

Paying someone to lose you money is insulting. But is paying someone a hefty rate to make you money anything other than marginally better?

Take the

Ameritor

funds, descendants of the once-miserable Steadman funds. In 1998, the $1.6 million Ameritor Investment fund showed a 50.6% return. But the fund also charged a hefty 14.54% expense ratio. And the Ameritor Industry fund, which posted an 18.3% return, had a total expense ratio of 22.57%, the highest ratio of any fund in

Lipper's

stock fund universe.

Max Katcher, who took over the funds' management at the beginning of last year after the death of Charles W. Steadman, says the high expenses are the result of numerous small accounts, which the company is now trying to phase out.

Ameritor hasn't been accepting new investments in the funds, and wants to weed smaller accounts out of them, to cut down on costs. The Industry fund alone has as many as 6,000 accounts, Katcher says, many of them with balances as low as $100. And he says his own trading style contrasts with Steadman's, which was notorious for keeping the expenses of the funds high.

"Basically he

Steadman was a person who liked to trade often. And consequently, we never really benefitted from appreciation in the stocks, because they didn't hold them that long," Katcher says.

That style made Steadman's turnover rate as high as 300%, Katcher says. He wants to keep his own to 50%. He boosted returns in 1998 by cleaning out the funds' portfolios, he says, dumping foreign, biotechnology and health-care stocks and replacing them with highflying tech names. As of Sept. 30, Ameritor Investment held

Lucent Technologies

(LU)

,

Cisco Systems

(CSCO) - Get Report

and

MCI WorldCom

(WCOM)

, according to

Morningstar

.

Knowing some of the worst expense ratio offenders of 1998 may not make it easier to look into the crystal ball of 1999 and figure out how to avoid negative returns. But you do have one possible way to limit the potential damage: Shy away from funds with unusually high expense ratios.