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Three Fee Benchmarks for Your Mutual Funds

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. If you are a regular reader of Morningstar.com, you know that we spend a lot of time talking about mutual fund fees. This might not be the most scintillating topic, but all of our research shows that they can have a big, big impact on your investing results. Here to tell us why is Morningstar's Christine Benz, Director of Personal Finance.

Christine, thanks for joining me.

Christine Benz: Jason, nice to be here and I find them scintillating by the way, this discussion of fund expenses.

Stipp: Well, you're going to tell us a little bit about why. So, if I'm on a Morningstar quote page and I'm looking at a mutual fund expense ratio, just at first glance, it can be hard for me to know if it's high or low, but also it seems like a pretty small number. It's usually point something, something. It doesn't seem like it would up add too much, but that's not necessarily the case.

Benz: No, they look so innocuous, don't they, and I think that's why investors often ignore them and the other thing is, you never write a check for these services. It's just this invisible hand that comes into your account and deducts the money, so investors don't pay a lot of attention but over time we have found that expense ratios are the most impactful single data point.

And if you focus on one data point and no other, you are probably better off focusing on an expense ratio that will help you fair it out the good performers from the bad ones.

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Stipp: So, do you have an example of what the actual impact of different expense ratios could be in dollar and cents?

Benz: Yes, a really simple example would be, say you had two funds tracking the S&P 500 and say someone put a $100,000 into each of them 10 years ago. One of them charged just 10 basis points, the other one charged a full percentage point. Over time, over the next decade, you would find that the investor who was in the cheaper fund, actually had $3,400 more than the one who was in the more expensive fund.

It may not sound like a lot, but over the past decade, investors in those funds would have had losses, so you'd be $3,400 ahead of the person who had the more expensive fund.

Stipp: And for two products that are essentially the same, they are following the same index, they are going to hold the same investments. To pay $3,400 more for one, just doesn't seem to make a lot of sense.

Benz: It doesn't, and that's why we've seen such price wars in the exchange-traded fund and index fund space because there is a lot of transparency there. These are commodity investments, so all things being equal, you might as well go with the cheaper fund.

Stipp: So, Christine, when I'm looking and trying to compare investments – if I'm looking for some place to put my money, how can I benchmark the expense ratios that I see on any given fund, a quick take, how do I know if its high or low?

Benz: One thing you might want to look at is, Russ' research. Russ Kinnel, Director of Fund Research here, has looked at what the cheapest quintile of various categories would return versus the most expensive. So, I did some quick breakpoints within various peer groups. If you look at large-cap, no-load, the cheapest quintile tops out at 85 basis points. So you want to look for expense ratios of less than 85 basis points for large-cap core no-load stock funds.

Stipp: And so obviously different types of funds will have different kinds of expense ratios, so that's for a large-cap stock fund. What about on the fixed-income side, and I know that fixed income, there the range of returns is usually tighter. So, the amount you pay is very important thing to take a look at, especially with bond funds?

Benz: Right. So you want to set the bar even lower there because of that tightly bunched range of returns and also just the returns are lower on absolute terms, so that expense ratio is going to take a bigger bite out of your return.

So the cheapest quintile in intermediate-term bond and muni intermediate-term bond is 60 basis points or 0.60%, so you want to try to keep it below that level if you possibly can.

Stipp: Another area, obviously, where investors are looking to put some money is overseas. These funds can tend to charge a little bit more than may be what you see in a domestic large-cap fund. What's a reasonable price and what's a good price to look for as a benchmark when you are looking at these mutual funds?

Benz: Well, here the cheapest quintile would be just about 1%. The second cheapest quintile is about 1.2%. So even though you will pay a little more, I am not quite convinced that you should pay a little more, but you will pay a little more than you would for domestic stock fund. You want to keep it probably under 1.2%, otherwise you are really stacking the odds against yourself in terms of that fund being able to deliver good performance in the future.

Stipp: Christine, these are good benchmarks and good key numbers to have in mind when you are looking at funds. How should I overall think about fees as I'm looking to make a decision or if I am assessing my own mutual funds--how should they factor into my potential buy or sell decision?

Benz: Well, really just one piece of the puzzle, Jason, because fund expenses are important part. But they are just one cost that you might pay, so you may have transaction costs if you are working through a broker. You may also have tax-related costs. So, even if you see something, see that your fund isn't the cheapest fund around, if you have a capital gain in it and you might also trigger some kind of a sales charge to get out of it and get into something else, those are costs worth considering.

So you actually do want to do the math before you just decide to glom on to the cheapest fund no matter what.

Stipp: Christine, thanks so much for your insights and when it comes to potentially saving thousands of dollars, it certainly is a scintillating topic.

Benz: Thanks, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.