Fund expense ratios headed up in 2009

Mutual funds fees will be going up next year, with market turmoil likely to be the main culprit. Stock funds could experience an average increase in expense ratio of 0.05 to 0.1 percentage points, said Jeff Tjornehoj, a Denver-based senior research analyst at Lipper Inc. of New York. And bond funds could go up slightly, maybe 0.01 to 0.02 percentage points, he added. In addition, as assets have declined this year, some funds that operate with break points may have dipped below that level, causing management fees to rise. "I absolutely expect fees will go up," Mr. Tjornehoj said. "A lot of fund complexes work on a sliding fee scale. There are break points where there is a margin where costs go down. Unfortunately, costs go up when assets slide back down below those break points." In the last downturn — the market peaked in early 2000 and bottomed in late 2002 — equity mutual funds in two study groups had an increase of 0.06 or 0.07 percentage points in the simple average expense ratio over that time period, said Brian Reid, chief economist with the Investment Company Institute in Washington, the main mutual fund industry group.

FIXED COSTS

Fixed costs are another pressure on expense ratios. These include trading, accounting, legal, audit and other servicing fees that have to be spread among fewer shareholders as assets retract. "This is the worst year on record for equity mutual funds," Mr. Tjornehoj said. Returns for the average equity fund are down about 40%, he said. Stock funds are not the only ones hurt. Bond funds are down about 4%, Mr. Tjornehoj said. In 50 years, there have been only seven years that bond funds posted negative returns, he said. The last time was 1994 when they were down 1.7%. Both market depreciation and redemptions have contributed to the decline in assets. Equity mutual funds have been particularly hard-hit, with record outflows of $48 billion in September and $69 billion in October, according to Chicago-based fund tracker Morningstar Inc. Worse still, investors are not even aware of the rising costs the funds may already be incurring. Shareholders get less of a return as a result of fee increases. "Fees are usually constantly being assessed," Mr. Tjornehoj said. "So incremental changes are already being made."

ANNUAL REPORTS

The increase may not happen this year, but maybe next year, said Andrew Gogerty, senior fund analyst at Morningstar. "I wouldn't be surprised to see expenses rise," he said. Shareholders may see this reflected in annual reports coming out in the first half of 2009, Mr. Gogerty said. "Should this exodus from equity funds continue or even slow and the market still goes down, it will affect expenses," he said. "You need both of these things to turn around to keep expense ratios at bay," Mr. Gogerty said. "It's more than likely that we'll see them tick up next year." But not all experts think that fees are destined to rise. "Ultimately, the markets will turn around, and once again, we'll see a steady decline of fees," Mr. Reid said. "This will be a temporary set of departures from that downward trend, but many funds could step in here, and they may look to other ways to absorb these costs." Assets have contracted, but services haven't changed, Mr. Reid said. "The realized fee will be higher unless the fund firm provides some kind of offset to those fixed costs," he said. "There are a number of ways that advisers can and do provide subsidies to the funds." Still, an increase in expense ratios won't be a good selling point in an environment where fund firms are trying to get investors back. "It's not uncommon for advisers to screen on performance but also on fee level," Mr. Gogerty said. "Ticking them higher than average could be a problem." While investors aren't focused on fees, advisers are, said Ivory Johnson, director of financial planning at Scarborough Capital Management Inc., an Annapolis, Md., firm with $400 million in assets under management. "Investors are looking at the bottom line — performance, but the adviser cares," he said. "If a fund goes up to 1.9%, from 1.4%, after they lost more than that [half a percentage point] in the market, I'll look at ETFs." The cost is part of the fund selection decision, said Chuck Gibson, president of Financial Perspectives, a Newark, Calif., firm with $50 million in assets under management. "I screen for expense ratios, but don't necessarily screen out funds," he said. "If a fund has a certain methodology that you cannot find anywhere else, you'll pay the price." But if the funds are similar, cost will be the deciding factor. "If you have to find an alternative fund, you also have to consider the tax implications if you want to get rid of that fund," Mr. Gibson said. "The fund may have made some money, because you bought it several years ago." Increases in fees may come first from smaller fund firms, said Ted Toal, senior partner at Triton Wealth Management Inc. in Annapolis, which has $90 million in assets under management. "The smaller fund companies that are struggling with assets will probably be the ones raising their fees," he said. "The larger fund companies have enough financial stability not to have to raise fees." And even a temporary increase won't sit well with some advisers. "It will leave a bad taste in my mouth," Mr. Gibson said. "When it's time to make a change on a fund, I would be more likely to change if they had raised the cost. I would think that they are taking advantage of my clients." E-mail Sue Asci at sasci@investmentnews.com.