Is My Fund Too Expensive?

Question: I understand the importance of keeping costs down on my mutual funds. But how do I tell if a fund is charging too much or has reasonable expenses?

Answer: You're right that expenses are among the most important data points to focus on when buying a fund. In fact, Russ Kinnel's study on expense ratios indicates that fund costs are among the most powerful predictors of whether a fund is likely to beat its peers--even better than the Morningstar Rating for funds. The study factors in survivorship bias, which is fund companies' tendency to drop funds with poor performance or low asset levels from their lineups.

Coincidentally, many of these dropped funds were high-cost funds. Not only are funds with high costs more likely than their lower-cost counterparts to be merged away, but they're also more likely to turn in a poor performance. Although it's true that there are a minority of expensive funds that have chalked up enough in investor returns to offset their hefty price tags, Kinnel's study showed that funds in the cheapest quintile of their peer groups beat the most expensive quintile by a compelling margin between 2005 and 2010.

How Much Does My Fund Cost?
Morningstar.com offers both absolute and relative data points to help investors pinpoint where their fund stands in terms of expenses. To find your fund's expense ratio, enter its name or ticker in the quote box on Morningstar.com. That will take you to the fund's quote page, which lists some basic information on the fund, including its expenses. The expense ratio shown at the top of this page is the prospectus net expense ratio, which is pulled directly from the fund's prospectus. It is a forward-looking measure that expresses how much the fund company anticipates charging its shareholders in the upcoming fiscal year; it also factors in any waivers or reimbursements. (Some fund companies may waive a portion of a fund's true costs for a period of time, often when a newly launched fund is getting up and running.)

How Expensive Is My Fund?
It's hard to look at that raw expense ratio and tell whether it's cheap or dear, however. Clicking on the Expense tab on the gray toolbar at the top of the fund's quote page allows you to see how your fund stacks up against other funds in the same category. A bar chart helps illustrate the comparison at a glance. The blue bar indicates the fund's annual net expenses during the past five years, and the orange bar indicates the category's average net expense ratio during the same five years. That's a useful starting point for determining whether your fund is cheap or costly.

However, it's worth bearing a few additional points in mind. First, be aware that historical category averages account for survivorship bias by including obsolete funds when calculating category averages during the time period when those fund were alive.

Also, category averages encompass a diverse array of funds, including those sold through different sales channels with different expense structures as well as passive and active strategies. For example, an index fund such as  Dreyfus S&P 500 (PEOPX) might look cheap in absolute terms, with an expense ratio of 0.50%, but it's actually quite expensive relative to other popular S&P 500 trackers. Morningstar fund Analyst Reports and Stewardship Grades do a good job of further contextualizing a fund's expense ratio to help you determine whether a fund is cheap or costly.