Watch Out for Rising Costs

Mutual fund expense ratios were flat to slightly lower in 2008, but you're likely paying more than that now. (To see all the data on asset class trends, click here.)

Looking at asset-weighted retail expense ratios from 2008, most asset classes saw a 1 basis-point drop or no change from 2007. Overall, the asset-weighted average annual expense ratio dipped from 0.88% to 0.87%, though U.S. equity funds rose a basis point. Bond-fund expenses dipped as did those of international-equity funds.

Unfortunately that trend has likely reversed, and many funds today are charging more. The reason is easy to see: Open end mutual fund assets (excluding money funds and ETFs) totaled $4.8 trillion at the end of March 2009, down sharply from $7.8 billion at the beginning of 2008.

In fact, Vanguard announced that expense ratios are rising at a bunch of its funds. The same is true elsewhere, but other fund companies are not calling attention to it.

It's not that fund companies or their boards are moving to raise fees. It's that mutual fund management fees have set breakpoints that trigger cuts or hikes as assets in the fund rise or fall. For example, a management fee at a fund might be 70 basis points for the first $1 billion, 65 basis points for $1 billion to $5 billion, and 60 basis points for all sums above that. Thus, shifts in assets automatically trigger cuts or hikes in fees.

The 2008 annual expense ratios understate the hike because they reflect what fundholders paid over the course of last year. Because assets today are down 30% to 60% from January 2008 at the typical equity fund, the 2008 expense ratio figures don't include the full effect of a fund's current fee structure. In fact, annual reports come out at different dates over the course of a year, so the 2008 figures are even more stale than that. Some are from the end of October 2008, and others are from before then.

To get a sense of where the figures are headed, I looked at prospectus net expense ratios. The prospectus net expense ratio reflects the fund's current fee level as of the time the prospectus is printed and can be a more timely measure of what to expect. It still can suffer from staleness because it's only printed once a year but at least it doesn't factor in the fee level from the prior 12 months. (You can see the different expense ratios for a fund on the Fees & Expenses tab of each fund's data pages.) However, you can't make this comparison with funds of funds because the annual report doesn't include underlying fund expense ratios but the prospectus expense ratio does.

The prospectus net expense ratios signal a reversal in the trend toward lower fees. Domestic equity funds' weighted average could rise by 2 basis points. International could pop up by 4 basis points. Taxable bonds should be the same, but munis could pop 4 basis points.

Funds most likely to be affected are those whose assets fell sharply and saw their expense ratios decline in recent years when assets were growing. So, besides looking at your fund's latest prospectus net expense ratio, you can also look at the  Fund Report page that shows past assets and expenses.

Vanguard made clear where expenses are headed.  Vanguard U.S. Value  had a 9 basis-point hike to 0.46%. Muni funds like  Vanguard High-Yield Tax-Exempt (VWAHX) and  Vanguard Intermediate-Term Tax-Exempt (VWITX) have gone from 0.15% to 0.20%.

The best things you can do to protect yourself from fee hikes is to shop for funds that are in the cheapest quintile so that even if they do have a fee hike the fund should still be quite cheap. 

But Shouldn't Fund Companies Cut Shareholders Some Slack?
In light of the losses fundholders suffered in the current bear market, rising expense ratios are going to be an awfully tough sell. It's one thing for a firm like Vanguard, where expenses are near their cost level and typically lower than everyone else's, but what about places were expenses are above average?

In those cases, I'd like to see fund directors and fund companies alike pushing back on higher costs and saying that they're going to take a hit along with shareholders and hold the line on higher costs in light of the big losses suffered by shareholders. But in most cases that won't happen. Fund company bosses are also under pressure from stockholders who have seen publicly traded asset manager stocks fall sharply. And in some cases fund companies are being readied for sale and are therefore doing everything they can to keep profit margins from falling further.

If you're worried about your funds' expenses rising, I'd suggest writing to the directors of your funds to share your views.

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