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Penny-Pinchers' Funds

Some of the mutual funds with our best grades also have the lowest expense ratios.

Despite claims by some mutual fund salespeople that high expenses somehow equate with superior performance, data from Ratings indicate that those who penny-pinch can do quite well in risk-adjusted returns. Ratings' database of open-end stock funds was screened to filter out new and unstable funds with less than $1 million in total net assets. We also included retail funds with initial investment requirements of no more than $50,000.

The 10,555 remaining funds were then reviewed to see how expense ratios and asset size affect our ratings grades, which are based on risk-adjusted returns. (All portfolio classes were counted as individual funds in the study.)

In most cases, the difference between a relatively high and low expense ratio amounts to a fraction of one percentage point. However, this could translate into a material difference over years of compounding. Ratings' grades consider only returns and volatility for the past three years, with extra weight given to the most recent performance periods. Even without allowing the fractionally lower expense burdens much time to build, the low-expense-ratio funds earned impressive grades compared with their pricier counterparts.

The bar chart below is based on funds with high vs. low expense ratios. It shows that in the C range of grades, which equate to hold recommendations, fund expenses didn't make a material difference among the grades.

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But in the buy-recommended A and B grade ranges, there was a higher percentage of funds with low expense ratios -- except for the top grade of A-plus, in which there is actually a slightly higher percentage of high-fee funds. Similarly, there was a smaller percentage of low-expense funds languishing in the sell-recommended D and E grade ranges.

Of the 10% of funds with the lowest expense ratios, only 26.4% fell into the sell-recommended category, while 25.6% of the top 10% of funds found themselves similarly classified. But 31.3% of the decile with the highest expense ratio were tagged with sell recommendations by Ratings, where they were kept company by 32.3% of the smallest TNA (total net assets) decile. Ratings' Grades for Highest and Lowest Expense Ratio Stock Funds

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We also found that the larger funds, in terms of asset size, did not saddle their holders with the higher expense percentages imposed by small funds, reflecting the smaller asset bases over which they have to spread their costs. The average expense ratio of the top 10% of funds, as ranked by total net assets, was 1% vs. 1.61% for the lowest 10%. That translated into a significant advantage in our ratings grades earned by the big boys. Ratings' Grades for Stock Funds by Asset Size

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Richard Widows is a financial analyst for Ratings. Prior to joining, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.