(MONEY Magazine) – Before you pat yourself on the back for all the money you've earned in mutual funds lately, you need to recognize that you're not the only one making out like a bandit. So are the fund companies that sold you your shares. Worse, many funds are collecting outlandish fees for mediocre investment performance.

The heart of the problem: As funds have grown bigger, they should have become more economical to own. And, in truth, many companies have passed along the savings to shareholders. Yet sadly, more than half of all stock and bond funds with 10-year records--56% to be exact--have actually raised fees in that time. That's why I call today's rising expenses the Great Fund Stickup. What's more, you may not be a totally innocent victim. If you've been letting your focus on high returns distract you from deciding how much you should pay for performance--or even worse, if you've been voting yes when your fund company asks for a fee increase--then you're an accomplice in your own victimization.

How bad is this crime? If fund fees ought to be 20% lower--as I'm going to document--then you and your fellow fundholders are being overcharged by $5.3 billion a year. That's $14.6 million a day, a number so huge that it makes an old-time bank holdup look like a squabble over pocket change.

If those garish aggregates don't grab you, think of the Great Fund Stickup this way. The more a fund company charges you--even if it's just a tenth of a point here and another tenth there--the less you keep. That might not hurt so much when returns are squarely in double-digit territory, as they have been lately. But wait until the markets hit a rough patch; then those fees will either magnify your losses or take a proportionately bigger sliver of your smaller gains. Says Barry Barbash, chief fund regulator at the Securities and Exchange Commission: "I'd rather have investors think about expenses now than wait until their returns come down and they're unhappy with the result."

Believe me, it pays to scrutinize fund expenses as closely as you do total returns. Over the past decade, the 20% of U.S. diversified stock funds with the highest expenses charged an average of 1.85 percentage points more in annual fees than the cheapest 20%. But those priciest funds earned an annual average of 1.91 percentage points less than the cheapest group.

The moral: On average, the more you pay the less you get. (See the graph below, at right.) Think of that the next time some hotshot fund manager tries to justify a price hike by citing his past investment results.

In a few minutes, I'll tell you how to defend yourself from the Great Fund Stickup. But first, some more facts:

--Funds are money machines. You might still think it's quibbling to worry about 1% or 2% in annual fund fees. Far from it. This year shareholders like you will pay $26.7 billion in fees (on $3.2 trillion in assets) to cover all mutual funds' operating expenses. (Sales charges, or loads, are another thing altogether; we're not tackling them here.) Of that $26.7 billion, fees for investment management will hit $16 billion; another $10 billion or so will go for such expenses as accounting, legal and marketing costs.

The bottom line? After you pay all these bills, the companies that run mutual funds post average net profit margins in the mid-20% range. That's more than triple the 7% net margin of the typical publicly traded U.S. company--and more than double what you can expect your funds themselves to earn over time. Want a comparison with names you know? Microsoft's 1996 net margin was 25.1%. Eat your heart out, Bill Gates. Fund giant Franklin Resources' 1996 net margin was 32.1%. "Managing money is the most profitable business in the United States," says Arthur Zeikel. He should know; he's president of Merrill Lynch Asset Management, the country's fourth largest fund sponsor.

--These money machines are breaking a basic business law. In most businesses, the more of a product you sell, the cheaper it becomes to produce and distribute. That's because the firm becomes more efficient as sales volume grows, reducing the cost per item. The more you pass on those reduced costs to your customers, the more competitive your product becomes.

But such economies of scale don't seem to hold for mutual funds. From 1986 through 1995 (the latest year with final data), total net assets of stock and bond funds rose nearly fivefold to $1.76 trillion. Did expenses drop? Au contraire. Stock and bond fund management fees (calculated as a percentage of assets under management) actually rose 11.8%, and overall expenses charged to shareholders have zoomed 22%.

--The fee heist isn't limited to newcomers run by struggling fund management companies. Not at all. Some of the biggest funds run by some of the most muscular, widely known management outfits charge fees at least 75% higher than their category averages. Two extreme examples: $2.7 billion Alliance Growth B charges total annual expenses of 2.05% of assets (vs. 1.07% for the average growth fund), and $956 million John Hancock Special Equities B has total expenses of 2.2% (vs. 1.25% for the average small-company growth fund).

Have I got your attention? Now let's move on to the details of fund costs--and what you can do about them.

First off: What are "expenses" anyway? Again, we're not talking about sales commissions or "loads." Rather, the topic here is money that fund sponsors siphon out of your account to pay for day-to-day operations. Your fund has a board of directors, which hires an investment manager to run your money; a transfer agent to process the transactions; a custodian to hold the assets in safekeeping; accountants to check the books; and lawyers to keep everybody honest. The fund may also pay an annual fee to brokers and financial planners who help peddle its shares. By far the biggest of these charges is the management or advisory fee charged by the investment manager; it usually accounts for at least 60% of a fund's total expenses.

None of these people ever send you a bill. Instead, their fees are quietly, continuously subtracted from your assets. That's why you may never have noticed how much you're paying (or overpaying). You're not alone. According to a recent survey by the SEC and the Office of the Comptroller of the Currency, fully 81% of investors say they couldn't even hazard a guess about what their largest fundholding charges for expenses.

Quietly or not, these fees corrode your account. Let's say you invest $5,000 in N/I Growth, a stock fund that charges a reasonable 1% in total expenses. Now let's say the portfolio steadily rises in value by 10% over the next year. That should turn $5,000 into $5,500. But you will have only $5,445 to show for it. Why? Because N/I Growth's management company, Numeric Investors of Cambridge, Mass., deducts its fees, as all fund managers do, in daily nibbles over the course of each 12 months. That slows the growth rate of your investment by preventing all your money from working for you for the whole year; in this example, it reduces your 10% gross return to just 8.9% net. Even though you paid only slightly over $50 in fees, the cost ate up more than 11.7% of your $445 net return.

Now say you had bought PIMCo Advisors Target C, which charges a high 2% in annual expenses, and earned the same 10% gross return. Your net return would drop to just 7.8%--and your total expenses would devour an appalling 26.7% of your net return.

After a decade of 10% gross annual returns, an investor in N/I Growth would have turned his original $5,000 into $11,734. But an investor in the PIMCo fund, earning the same 10% before fees, would finish with only $10,616. This $1,118 gap, produced by the difference between the two funds' expenses, is a giant 22% of the $5,000 you started with. That's the black magic of de-compounding, by which subtracting a small amount for fund expenses each year makes much of your future wealth vanish.

High expenses can also turn a stock fund into a bond fund. How so? If you're a stock investor paying 2% in fund fees plus another 1% to a financial adviser for monitoring your funds, your 3% annual costs are eating up the entire amount by which stock returns have exceeded bond returns in the long run. No wonder Morningstar president Don Phillips somberly told me, "I'm beginning to despair about the future of mutual funds as a low-cost option for investors."

Ralph Wanger, the co-manager of the outstanding Acorn Fund (total annual expenses: a very low 0.57%), agrees. "It's gotten to the point where the fund industry has a basic flaw in its design," he warns. "Unless fees come down, investors will get tired of being hosed, and they will find another way to invest."

Where did funds go wrong? In 1986, stock and bond funds had $383.9 billion in assets; by the end of 1995, they had $1.76 trillion--nearly quintupling in size. By all rights, that asset growth should have showered fund investors with economies of scale. It didn't. Back in 1986, the average stock and bond fund charged 0.515% in management fees and 0.81% in total expenses. By the end of 1995 (the latest available data), the average management fee had risen to 0.576%, while total expenses had bloated to 0.988%. (See the left-hand graph on page 64.) Moreover, these numbers, from Lipper Analytical Services, are conservative because they are weighted by the size of the funds that make up the averages.

In short, far too many funds have been delivering diseconomies of scale. Generally, running a fund becomes profitable for the manager once the portfolio hits $100 million or so in assets--so, beyond that point, there's room for fees to fall. Yet, according to Morningstar, 182 of the 2,555 stock or bond funds with $100 million or more charge at least 2% in annual expenses (for the 10 biggest offenders among diversified U.S. stock funds, see the table at right).

For a closeup of diseconomies of scale, consider Seligman Frontier. Back in 1986, this fund had only $17.6 million in assets and charged 1.06% in annual expenses. By the end of 1995, it had $335.3 million in assets but was charging 1.43% in total expenses. In other words, after growing nearly twentyfold in a decade, Seligman Frontier was charging investors 35% more for its services. At this point you might think the manager, J. & W. Seligman & Co., would finally cut its fee. Guess again. Last January the firm raised its management fee another 26.7%, jacking up the fund's total expenses to 1.63%. (Seligman did not respond to our requests for comment by press time, but its proxy statement said the fee hike "would enhance the manager's ability to attract and retain highly qualified investment and administrative professionals.")

Seligman is far from the only violator. Look at Kemper Growth A. In 1987 it had $275 million in assets and charged 0.8% in annual expenses. After raising its management fee by 10% in 1994, it now has $1.8 billion in assets and charges 1.17%. Or consider Putnam Income A. In 1987, it had $335 million in assets and levied 0.78% in annual expenses. After a 62% management-fee hike in 1995, Putnam Income now charges shareholders 1.05% in total expenses at its current assets of $1.5 billion. Or ponder fast-growing PBHG Growth. Ten years ago, on just $27 million in assets, this fund charged 1.31% in annual expenses. Today, after a 70% management fee increase in 1994, the fund has $6 billion in assets but charges 1.45% in annual expenses.

Ask the sponsors of funds like these why fees are high, and you'll get answers along these lines: Superstar portfolio managers can command several million dollars a year in pay; computers must be continually maintained and upgraded; every company in a portfolio must be researched (often by traveling to far-flung corners of the world); toll-free service lines must be staffed 24 hours a day. All of this costs tons of money.

Fair enough. But even so, investors in the United Kingdom could teach U.S. money managers a thing or two about pinching pennies. Foreign & Colonial Investment Trust, the world's oldest fund, began life in London in 1868, charging a maximum of 0.42% in annual expenses over its first five years. Today it charges just 0.47%--a 12% total increase in nearly 130 years. By contrast, as I've noted, the expenses at U.S. funds have increased nearly twice that much in just 10 years.

A little more history: Back in 1960, the managers of 73% of U.S. mutual funds paid for the funds' bookkeeping; 60% paid the funds' accounting fees; 11% paid for processing purchases and sales. Today most fund companies force their customers to pay those costs. But even after covering all those costs back then, fund managers still ran an average net profit margin of 18%. That's why I say that, given today's net margins in the 25% neighborhood, fund companies could easily cut their overall fees by at least 20%--$1 in $5--and still remain immensely profitable.

Just how lucrative is it to run a fund company? Well, even with his low management fees of 0.6% or so, Michael Price's investment firm, Heine Securities, earned $62.5 million in net income on its fee revenue of $95 million in the year ended last June. That's a net profit margin of 65.8%, or more than eight times higher than the average U.S. corporation's. That's one reason why Price was able to sell his firm, which was managing $17 billion, to Franklin Resources for as much as $800 million late last year--a rich price of more than 4% of total assets.

Another example: This year, Kaufmann Fund shareholders will pay their investment adviser, Edgemont Asset Management, at least $72 million in management fees. Assuming a net (pretax) margin of 50%--which, several sources tell me, may be conservative--Edgemont's two owners, Lawrence Auriana and Hans Utsch, will take home at least $18 million each in 1997.

To be fair, Kaufmann's total expenses have dropped from a steep 3.64% in 1991 (on $140 million in assets) to 2.17% in 1995 (on $3.2 billion) to 1.94% last year (on $5.34 billion at year-end). But the 1.5% management fee that Kaufmann shareholders pay to Edgemont is one of the highest in the business, and it has not fallen at all. "Someone has to have the highest fee," Auriana says, "and I guess we're the ones. Fortunately enough we've done pretty well for our shareholders." No argument there: Over the past five years, Kaufmann's 18.9% average annual return wallops its peers by 5.2 percentage points. Of course, the fund may not always perform so well in the future, but Auriana says firmly: "I see no reason to lower the [management] fee."

Yet plenty of managers have delivered above-average returns at below-average cost--and have cut those costs as their funds have grown. The American Funds' EuroPacific Growth, for instance, charged a total of 1.27% annually back in 1987 on $185 million in assets; by 1996, assets were up to $15.4 billion and expenses were down to just 0.95%. In 1987, on $1.1 billion in assets, Fidelity Growth & Income charged 1.09%; by last year, it had $23.7 billion in assets and expenses were down to only 0.75%. And T. Rowe Price Growth & Income charged 1.03% on $366 million in 1987; by 1996, its fees had fallen to just 0.83% on $2.5 billion.

Robert Marcin is co-manager of the MAS Value Fund (assets: $2.4 billion), which has beaten the S&P 500 by an annual average of 0.3 points over the past decade. His firm charges only 0.5% in management fees and 0.61% in total expenses. "A money manager can clearly run funds very profitably for 0.5% to 1% total," Marcin says. "Anyone who tells you otherwise is full of poop."

Marcin is right. Now here's what you should do.

--Remember what you're paying for. Over the long run, even the best managers--stars like Mario Gabelli, John Neff and Michael Price--have a hard time beating the market average by more than one or two percentage points a year. A manager charging 2% in annual expenses has to outrun the market by more than two points just to stay even with the average. The higher the fees you pay, the worse are your odds of outperforming.

In the debate over whether the past returns of mutual funds can predict future returns, academics and fund analysts alike agree on only one thing: On average, funds that charge higher expenses will have lower returns. Since you can never be sure which funds will end up with the best future performance, but you can be certain which funds will have high expenses, you should avoid them.

Here are my rules of thumb on fund costs. First of all, if you want to work with a broker, don't begrudge her a fair sales commission, which tops out at about 5.75% on stock funds these days. Get it over with by paying up front, through the so-called Class A shares; if you choose another share class, the higher fees will eat away at your returns as long as you own the fund. Instead, zero in on the fund's annual expenses, which are disclosed in the beginning of the prospectus. (If you really can't abide the broker's sales load, then you should buy a no-load fund.)

For a bond fund, don't pay more than 0.75% in annual expenses; among the excellent high-grade choices in that price range are Harbor Bond, Benham GNMA Income and Vanguard Total Bond Market. If junk or high-yield funds are your pleasure, pay up to 1% for good funds like Fidelity Capital & Income, Nicholas Income and Vanguard High-Yield Corporate.

For a blue-chip U.S. stock fund, draw the line at 1% in annual expenses; Dodge & Cox Stock, Fidelity Fund, Janus Fund and Vanguard Index 500 (or Vanguard Total Stock Market) all charge less than that.

For a small-cap fund, don't pay over 1.25% in expenses; good picks under that limit include Wanger's Acorn Fund, Babson Enterprise and T. Rowe Price OTC.

For international stock funds, keep your costs below 1.5%; here you can choose from Scudder International, Vanguard International Growth or Warburg Pincus International Equity.

All these funds have delivered solid returns without taking more than they should in expenses. Anytime you pay more than these guidelines, the odds are stacked against you.

--Don't let a fund manager hold a gun to your head. At the end of 1993, the American Heritage Fund had a phenomenal three-year annual average return of 48.9%. So when portfolio manager Heiko Thieme asked shareholders to approve a 67% increase in his management fee, they gave him the thumbs-up. Instead, they should have told Heiko to take a hike. In the three years since, the fund has lost an annual average of 24.3%. The lesson: Good returns can disappear in a flash, but expenses are forever. Don't buy the argument that hot results deserve to be rewarded with higher fees.

And that's why, when your fund company sends you a proxy statement, you must read it. You're being asked to vote on your future--and you can't take it lightly. My advice (and I'll admit it's uncompromising): If the proxy asks you to authorize an increase in the manager's investment advisory fee, you should always vote no. Then you should vote against the re-election of every single fund director on the ballot. These people have let you down by failing to make your fund more economical, and you should vote to fire them.

Only if you fight back like this will the fund industry begin to charge a fair price for its services. And if you don't, you'll have no one but yourself to blame.

Let me finish with this question: Would you let your accountant charge you 20% of your net income for filling out your tax return? Of course not. But, if stock returns revert to their long-term average of 10%, a fund company that charges 2% in annual expenses will be keeping at least 20% of your returns. Ask yourself: If I would never pay an accountant 20%, why on earth should I pay a fund manager that much?

It's not fair, and it makes no sense. Don't do it.