Low Fees in a Small Package

Regular visitors to Morningstar.com are probably familiar by now with the idea of cost-conscious fund investing and why it's so important. To review, the amount a fund company charges investors to own shares of its fund--referred to as a fund's expense ratio, fees, or costs--is subtracted from fund returns. As a result, funds that charge low fees are able to pass on more of their total returns than those charging higher fees.

Funds with large asset bases often have a built-in advantage over their smaller peers when it comes to fees because economies of scale allow them to spread the cost of operating the fund more broadly. For example, whether a fund has an asset base of $5 billion or $50 billion it still must pay a manager and analysts to run the portfolio along with noninvestment expenses such as plan administration, customer support, marketing, and other costs related to running the business.

True, a larger fund may have higher overall operating costs that come with providing services to a larger customer base and paying higher salaries to the fund's manager and a larger team of analysts. But typically the larger a fund grows, the smaller these costs become as a percentage of assets. That's one reason Morningstar fund analysts often look at a fund's asset base when determining whether its fees are fair or not. A fund that has increased assets dramatically over time without reducing its fees risks being called out for not passing on part of its cost savings to shareholders.  

As a point of comparison, consider that the average large-cap fund with at least $10 billion in assets charges 60 basis points in annual fees whereas the average large-cap fund with $1 billion or less in assets charges nearly twice as much at 114 basis points. (These figures include load funds and large-cap index funds, which typically have lower expense ratios than their actively managed counterparts because of lower research and trading expenses. Take out index funds and the figures rise to 73 basis points charged by large-cap funds with asset bases of $10 billion or more and 117 basis points for those with $1 billion or less.)

As funds grow larger and are able to lower their expense ratios, they may attract new business partly because of the fact that they cost less to own. But bigger is not always better. For example, a small-cap fund that becomes too large may find it difficult to find small companies in which it can invest without running up the stock price. Sometimes smaller is better. But finding smaller funds with low expense ratios can be a challenge, which is why we'll turn to Morningstar's  Premium Fund Screener for help.

We screened on stock funds with asset bases of $1 billion or less and below-category-average expense ratios (keep in mind that this metric looks at all funds within a category, whereas the fee-level comparison methodology looks only at similar funds that use the same sales structure, such as no-loads versus no-loads, front-loads versus front-loads, and so on). We stuck with no-load funds and left out institutional funds and those that are currently closed to new investors. To ensure these smaller funds have been vetted for factors such as management, process, and performance, we included only those with Morningstar Analyst Ratings of Bronze or better. Premium Members can see the full list  here. Funds on the list include the following:

 Bridgeway Ultra-Small Company Market (BRSIX)   
Expenses: 0.75%     
At first blush, 75 basis points for a passively managed fund might seem rather high. But this small-blend fund is one of the only ways to buy the smallest 10% of companies on the New York Stock Exchange. Holdings average just $175 million in market cap, and the fund rebalances to realign with its index just once a year in order to limit the volatility and illiquidity common at the shallow end of the market-cap pool. The fund doesn't own all the stocks in the index it roughly tracks, which means it typically loses less in downturns but lags in rallies. The fund has a somewhat higher weighting in financials (24% of assets) and health care (14%) compared with its small-blend peers.

 FPA Perennial    
Expenses: 1.02%    
A focus on quality mid- and small-cap companies and a buy-and-hold approach distinguish this fund from its mid-growth peers. Its managers favor companies with high returns on capital, solid growth prospects, and low debt levels. They run a concentrated fund of 35 names with top holdings including  O'Reilly Automotive (ORLY), Signet Jewelers (SIG), and  CarMax (KMX), each being about a 7% weighting. The fund is overweight industrials and consumer cyclical stocks, making up more than two thirds of the portfolio combined. The fund also has a strong long-term track record and outperformed its mid-growth peers by 6 percentage points amid the market downturn in 2008 and by more than 7 points when the market rebounded in 2009. Low turnover (2%) helps this fund keep expenses below-average for a no-load, mid-cap fund.

 Wasatch Core Growth (WGROX)   
Expenses: 1.23%  
This small-growth fund's compact portfolio reflects its managers' focus on stocks with high economic returns, strong management teams, defensible business models, and consistent earnings across economic cycles, with more of an eye on valuation than found with sibling  Wasatch Small Cap Growth (WAAEX). The fund is prone to lopsided sector allocations, with current overweightings in industrials (33% of the portfolio), financials (15%), and consumer cyclical (23%) stocks. The fund has outperformed its peers and benchmark by an average of 4 and 5 percentage points per year, respectively, during the tenure of senior manager J.B. Taylor, which began in December 2000 (through April 14, 2013). Turnover is low at 28%, and expenses (1.23%) are below the category average of 1.45%.

Portfolio data as of March 31.