HOW FUND COSTS DRAG DOWN GAINS
By MICHAEL BRUSH

(MONEY Magazine) – If you could single out one piece of information that would give you the best insight into a mutual fund's chances of outperforming its peers, what would you choose? Five-year performance? One-year performance? The fund manager's IQ? Tempting as it may be to think otherwise, no information about a fund or its past allows you to predict with certainty which fund will beat the pack in the coming years. But one factor clearly tilts the odds: the fund's cost.

Most investors know that seemingly insignificant expenses, levied year after year, can cripple their returns just as a snagged line can hamper a climber's assault on a mountain peak. But judging by their enthusiasm for high-expense funds, most investors haven't taken the message to heart. If you're one of them, consider this: In a study of what factors predicted the performance of all U.S. diversified stock funds between 1962 and 1993, University of Southern California business school professor Mark Carhart found that annual expenses were the single best forecaster. "After studying lots of funds," says Carhart, "I'm convinced that investors should spend their time looking at costs, not at past performance."

The implications are clear. Once you've narrowed your choice to the kind of fund you want--based on investing style and level of risk--the next thing you should do is bargain hunt for the funds that charge the least. Unfortunately, because the way expenses are passed along to shareholders varies so much, that search isn't easy. But this story will help you demystify fund fees once and for all. Understanding and minimizing those expenses is one of the few surefire ways to boost your fund returns.

Basically, you face two kinds of costs: sales charges and annual operating fees. Sales charges, levied on funds distributed by brokerages, banks and other sales outfits, can range from fractions of a percentage point each year to one-time whacks of up to 8.5%. Annual operating fees of 0.2% to 3% each year cover investment management and administration, and are an unavoidable part of all fund investing. Here's what you need to know about them both:

--The annually recurring expenses are the most insidious. The key measure of a fund's yearly expenses is the so-called expense ratio, which records ongoing fees as a percentage of total assets. The costs that go into the expense ratio include investment management fees, administrative expenses, shareholder services like 800 lines, and in some cases, a so-called 12b-1 fee, which many funds levy to cover the costs of marketing the fund (including advertising in magazines like MONEY). You can find any fund's expense ratio in its prospectus (as well as in MONEY's semiannual fund tables). Otherwise, though, the expenses are invisible: The fund company extracts them from the fund's assets--and your pocket--before reporting returns.

However, like termites, they can do plenty of damage over time. Each percentage point of expense ratio reduces your return by the same amount. To see the effect, look at a fund like Van Kampen American Capital Emerging Growth, which offers shareholders a choice of class-A shares and class-B shares. (As explained below, the two classes are identical once you buy them, except that A shares have lower expense ratios.) The A shares invariably have slightly higher returns than their more expensive siblings, and as that difference compounds over the years, the advantage widens. Over the past five years, the A shares have grown 127%, the B shares 117%.

So exactly how much is too much to pay in mutual fund expenses? As a simple rule, start by never paying more than the average for the type of fund you are buying. But financial advisers like James Stack, editor of InvesTech Market Analyst, suggest you set even tougher standards. (See the table below for the average expenses and suggested thresholds for 12 fund categories.) For example, avoid blue-chip U.S. stock funds that charge more than 1% a year. But at an international equity fund, which tends to require more costly research, a reasonable cutoff is 1.5%.

Many investors seem willing to overlook high fees in the mistaken belief that paying a premium for a hot fund manager will pay off in high-octane returns. In fact, on average the opposite is true. In a study of the link between fees and fund performance between 1971 and 1993, Princeton University professor Burton Malkiel found that high-expense stock funds trailed low-expense funds by 1.9 percentage points a year, even though the fee gap was only one percentage point. Malkiel, who serves on the board of directors of several funds managed by low-cost champion Vanguard, theorizes that the managers at high-cost funds tend to move in and out of stocks more often in pursuit of high gains to compensate for the fees. But their high trading costs drag down returns even more.

With bond funds, it's even more important to keep an eye on expenses. Bond fund managers have little room to outperform a competitor, because individual bonds typically offer a more narrow range of returns than stocks. So on a government bond fund, look for expenses no higher than 0.65% of assets per year.

--If you buy from a broker, you always pay a commission one way or the other. While every fund has an expense ratio, only those sold by brokers carry an additional sales charge, or load. No matter what anyone tells you, loads serve no purpose other than to pay the fund's sales force. So before you buy from a salesperson, make sure the advice you get will be worth the price.

Unfortunately, it isn't always easy to determine what that price really is. In the name of giving investors more choice, fund companies that use salespeople to sell their funds have created an alphabet soup of share classes, all of which impose their sales charges in different ways at different times. To complicate matters more, each class usually carries a different expense ratio. Plus, all fund companies don't use the exact same names for each class.

In general, however, there are three basic share classes: A, B and C. About half of all broker-sold funds have what's commonly called an A share. A-share investors pay an initial sales charge of 4% to 6%--which means you'll put that much less money to work at the outset--plus the usual yearly expense ratio of 0.7% to 1.5%.

When you buy B shares, you don't pay the sales charge until you sell the fund. This so-called back-end load typically starts at 4% to 6% in the first year but then declines gradually until it is phased out by the fifth or sixth year. In order to make up for not collecting a sales charge at the beginning, if ever, these shares usually carry higher expenses every year--typically about 2%. Chances are a large proportion of that annual expense is a so-called 12b-1 fee, which compensates the salesman who sold you the fund. The one consolation, though, is that B shares usually convert to lower-expense A shares once the back-end load has expired.

The final variation, a "level load," or C share, typically carries the highest annual expense, often more than 2%, including a 12b-1 fee to pay the commission. Unlike the fee on a B share, the C share's 12b-1 is permanent. But its front- or back-end sales loads will be just 1% or so.

How do you choose the right class? "Your decision should have everything to do with your time horizon for owning the fund," says Jim Raker, a senior research analyst at Morningstar. If you plan to hold the fund for seven years or more, A shares are probably the most cost-effective. You pay more at the outset but benefit over the long haul from lower yearly expenses. Because of their relatively high expenses and back-end load, B shares can be the cheapest option only if you plan to hold them until the sales load disappears--after about five or six years.

If you buy and sell funds frequently, C shares are your best bet. While the annual fees are costly, you don't get nicked by a high sales charge each time you swap funds. For example, if you invest $10,000 in MFS Emerging Growth A shares and C shares, at the end of three years your A shares will be worth $11,780, assuming 9% annual portfolio returns. But because you avoided paying the 5.75% front-end load, your C shares will have grown to $12,240, despite higher annual expenses.

--You have a say in setting fund expenses. You can take heart from one aspect of fund fees: Fund companies cannot raise expenses without the approval of two-thirds of the shareholders. Unfortunately, most proposed fee hikes do take effect, at least partly because shareholders ignore the proxy statements that ask them to vote on the issue. But not always. Shareholders in USAA Aggressive Growth Fund last November rejected a proposal that would have raised their annual expenses by 46% (to 1.08% from 0.74%). And, of course, you can always vote with your feet and replace your fee-grabbing fund with a lower-cost alternative. Either way, you then can go on to ascend stock and bond market heights unencumbered.