Vanguard Group recently raised fees on some of its mutual funds. The expense ratio for the Intermediate-Term Tax Exempt Fund ( VWITX - Get Report) climbed to 0.2% from 0.15%. It rose to 0.46% from 0.37% on the U.S. Value Fund ( VUVLX). The news shocked some shareholders because Vanguard has always been viewed as a low-cost mutual fund manager. Has Vanguard changed its philosophy? Hardly. The rising costs are a symptom of a weak stock market that has lowered Vanguard assets by $300 billion in the past year to $1.06 trillion. At the same time, the fixed costs of managing portfolios have stayed about the same. In rising markets, Vanguard passes on declining costs to shareholders. Now investors must shoulder a heavier load. Vanguard isn't alone. In the past year, the expense ratio of the Fidelity Small Cap Stock Fund ( FSLCX - Get Report) increased to 1.08% from 0.8%, while the ratio on the American Century Small Cap Value Fund ( ASVIX - Get Report) rose to 1.49% from 1.26%. The average expense ratio, or cost per dollar invested, for domestic equity funds was 1.03% in 2002, according to Morningstar ( MORN - Get Report). As assets climbed, expense ratios dropped to 0.87% in 2007. That trend reversed last year, when the average ratio climbed to 0.88%. Morningstar predicts that expense ratios will rise further in 2009. Should you sell a fund because it has become more expensive? Not if the fund is cheaper than most of its peers. But steer clear of funds with above-average expenses. Funds with low expenses usually outperform high-cost funds. Recent research by Morningstar suggests they're also most likely to be merged out of existence or liquidated in bear markets.
In a typical pattern, a fund company opens a new fund with a high expense ratio. Burdened by high costs, the fund underperforms its peers and attracts few investors. That results in skimpy profits for the company, which shuts down the lemon. Unlucky shareholders might get a check in the mail -- along with a tax bill if the liquidation generated capital gains. To measure the cost of liquidations, Morningstar divided funds into five groups based on their expense ratios. Among domestic stock funds, 49% of the most expensive funds shut down within 10 years, about double the rate for cheap funds. So investors who buy an expensive fund must recognize that it could be headed for extinction. For some categories, the attrition rate was especially high. Of expensive international funds, 57% shut down in 10 years. Expensive taxable bond funds also recorded a failure rate of 57%. The chances of extinction often increase in bear markets. Last year, 415 funds closed, compared with 363 in 2007. That's why some researchers say investors should stick with index funds and avoid actively managed funds, which attempt to beat benchmarks and charge higher expenses. But that's not always the best approach. Index funds are typically cheaper because they don't spend money on active stock picking. However, there are some expensive index funds. According to Morningstar, 70 index funds charge 1% or more, an unreasonably expensive rate in most cases. There are also many cheap actively managed funds. One of the most notable is the Vanguard Health Care Fund ( VGH), which comes with an annual expense ratio of 0.26%. Odds are high that cheap active funds will outdo expensive index funds.
Proponents of high-cost funds sometimes argue that the high fees are justified by big returns. Consider the Federated Kaufmann Fund ( KAUAX - Get Report), which has a higher-than-average expense ratio of 1.99%. Despite the burden of extra costs, the fund has outdone 91% of its midcap growth competitors during the past decade. Federated shareholders may be pleased with the performance, but they should recognize that expensive funds face special obstacles in difficult markets. In an era when managers of all kinds are struggling, it's hard to stay in the black when a big percentage of returns are eaten away by expenses.