ETF, Mutual Fund, Hedge Fund Fees Fall

NEW YORK ( TheStreet) -- With much fanfare, Charles Schwab ( SCHW) started selling a group of low-cost exchange traded funds.

Some of the offerings come with the smallest expense ratios in the industry, and Schwab clients can trade the new funds for free. "No-commission trading has never been offered before, so Schwab is raising the heat on the competition," says Tom Lydon, editor of ETFTrends.com.

In its effort to cut expenses, Schwab is hardly alone. Investment managers of all stripes have been reducing costs. Expense ratios have been falling for ETFs and open-end mutual funds. Even hedge funds have been cutting the fees they charge to institutions and wealthy individuals.

Some of the fee cuts appear to be temporary measures aimed at helping companies attract customers during hard times. But the trend of lower expenses seems likely to continue even when the recession ends. As increasingly sophisticated investors comparison shop on the Internet, they are gravitating to the best bargains.

The Schwab discounts are particularly notable because they undercut competitors that had long offered cheap expense ratios. With an expense ratio of 0.15%, Schwab International Equity ETF ( SCHF) underprices its largest competitor, iShares MSCI EAFE ( EFA), which has $35 billion in assets and charges 0.35%. Schwab U.S. Broad Market ( SCHB) charges 0.08%, competing against S&P 500 trackers, such as SPDRS ( SPY) and iShares S&P 500 ( IVV), which both charge 0.09% and hold a combined $90 billion in assets.

The most notable element of the Schwab campaign is the free trading. Till now, investors buying ETFs have had to pay standard brokerage commissions for all trades. Retail investors with accounts of less than $1 million typically pay $12.95 for each trade at Schwab. The fees have made it prohibitively expensive for investors to put small amounts into ETFs. But that has changed. "If you are a Schwab client, it now makes sense to put $200 a month into an ETF," says John Gabriel, an ETF analyst for Morningstar.

Like ETFs, open-end mutual funds are also cutting costs. Funds that recently cut expense ratios by more than 20 basis points include Arbitrage ( ARBFX), Longleaf Partners International ( LLINX) and Schwab 1000 ( SNXFX).

At the same time that some individual funds have been cutting expenses, many shareholders have been reducing their total costs by selling expensive funds and shifting into cheaper selections from low-cost fund groups, such as Vanguard Group and T. Rowe Price ( TROW).

Because of this migration, the expense ratio imposed on the average dollar invested in domestic equity funds has dropped to 0.78%, down about 0.2% in the past five years, according to Morningstar. Part of the reason for the decline has been the movement into index funds. While some index funds continue to charge steep fees, the vast majority of index investors have preferred low-cost selections. Popular choices include Vanguard Total Stock Market ( VTSMX), which charges 0.18%, and Fidelity Spartan Total Market Index ( FSTMX), with expenses of 0.1%.

Cash has recently been moving out of high-cost actively managed funds and into index funds. According to Morningstar, stock index funds have received inflows of $30 billion this year, while active stock funds have faced outflows of around $16 billion. Of the $4 trillion in stock mutual funds, 17% is in passive funds. That's up from 14.5% in 2006.

Brad Hintz, an analyst at Sanford C. Bernstein, predicts that the flow of assets into index funds and ETFs will continue. That should push down average expense ratios even further. Hintz notes that institutional investors currently have 30% of their assets in passive funds, up from 20% a decade ago. He expects retail investors to follow a similar path. Hintz predicts that assets in ETFs will grow at a 20% annual rate for the next three years.

While mutual fund investors have been shopping for low costs, some of the most dramatic price cutting has occurred among hedge funds. Seeking to serve sophisticated investors, hedge funds have traditionally charged 2% annual expenses plus 20% of all the profits. Those are outsized costs that can only be justified by unusual returns. But lately some institutional investors have decided that hedge funds have been overcharging. Giant pensions, such as Calpers and Utah Retirement System, have begun bargaining for lower fees.

Many pensions report that they are winning concessions. Though most investors continue paying 20% of the profits, the average annual fee is now 1.63%, according to Preqin Ltd., a consulting firm. Preqin says 27% of institutional clients pay less than 1.5%. Surveying institutions, Preqin found that half had sought lower fees. Of those that negotiated for reductions, 62% won them. "A lot of hedge funds need new investors now, so they have become more flexible about what they will charge," says Amy Bensted, an analyst at Preqin.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.