From the August 2005 issue of Entrepreneur

The rise of exchange-traded funds, the increasing popularity of index funds and the backlash of industry scandals are putting pressure on mutual fund companies to reduce their fees. Since last fall, the two biggest fund providers, Fidelity Investments and The Vanguard Group, have been publicly trying to one-up each other over whose fees are more shareholder-friendly. Other issuers have cut fees, too, even as the SEC prepares to force fund boards to start detailing how they set expense ratios. Meanwhile, the bargain-basement cost structures of exchange-traded funds and index funds continue to attract a growing share of the industry's money. The upshot: The average expense ratio dropped slightly in 2004 and appears to be dipping further in 2005, according to Morningstar Mutual Funds.

But Morningstar's director of fund research, Russel Kinnell, wants to throw cold water on any warm fuzzies you may be feeling toward the industry. The amount of money in U.S. mutual funds has grown tenfold since 1989, he points out, generating huge economies of scale. Yet the average dollar-weighted expense ratio has increased in that time from 0.94 percent to 0.96 percent, if you factor out deals given to large, institutional investors. Most of the money saved through the economies of scale has gone to brokerage houses and fund companies rather than small-fry investors.

"Trumpeting lower fees is like saying it got cooler in Cairo," Kinnell says. "It went from 100 degrees to 95 degrees, but it's still too hot." To make matters worse, he argues, the massive increase in assets at many funds makes them less flexible and less able to deliver market-beating returns. So investors are paying as much as--or more than--they were 10 or 15 years ago, but receiving less in return.

So buyer, beware of letting down your guard when it comes to fund fees. Some companies pass along their economies of scale to investors; some don't. Past performance, as the small print always states, is not a reliable indicator of future returns. But expense ratios just might be. In the fund industry, paying more has little correlation with quality. Often, you'll find just the opposite is true.


Scott Bernard Nelson is assistant business editor at The Oregonian and a freelance writer in Portland, Oregon.