Mutual Funds April 12, 2010, 8:55PM EST

Surprise: Fund Fees Hold Steady Amid Market Rally

As competition keeps mutual fund expense ratios down, investors must watch for fees—or cuts in research spending—that can erode portfolios

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(Adds Investment Company Institute data in the third paragraph.)

For investors, mutual fund fees are about the only things that haven't been turned upside down by the Great Recession and wild markets of the last couple years.

Data from Morningstar (MORN) put the expense ratio for the average U.S. stock or bond fund at 1.24% as of Apr. 8. That's the same ratio that prevailed at the end of both 2008 and 2009.

Using a different methodology, the mutual fund trade organization Investment Company Institute released estimates on Apr. 13 showing investing costs were unchanged in 2009. The average investor paid total fees and expenses of 0.99% on equity funds and 0.75% on bond funds last year, the institute said. Both were the same as 2008 estimates.

Expenses have held steady even as fund managers' revenue was slashed, then restored somewhat by the stock market's resurgence. The broad Standard & Poor's 500-stock index fell 57% from its Oct. 9, 2007 peak to Mar. 9, 2009, but has since rebounded 77%. The index on Apr. 12 was 24% off that 2007 high.

Investors have been yanking money from equity mutual funds at a rapid rate, further reducing the amount managers collect from expense ratios, which are charged annually on a percentage of assets under management. According to TrimTabs Investment Research, investors pulled $36.2 billion from U.S. equity funds in 2009, following withdrawal of $162.4 billion in 2008. Bond mutual funds saw $463.8 billion of inflows in 2008 and 2009.

Profit margins in the mutual fund industry have been squeezed, says Sean Collins, senior director of industry and financial analysis at the Investment Company Institute. "There is pretty strong competition in the business for investor dollars," Collins says. "That keeps people on their toes."

Fund fees compound year after year

Investing experts still believe that many people are overpaying for mutual funds management and other investment advice.

"Over the short term, [fees] might not seem significant," says Stephen Horan, head of private wealth management at the CFA Institute, the independent organization that awards the chartered financial analyst designation. However, he points out, a 1.5% annual fee can cut a portfolio by about one-third over 30 years. Because the fee compounds year after year, its bite is relatively constant, even if annual returns vary: A fund with a 5% annual return will lose 35% in fees over 30 years, while a fund that returns 10% loses 34% in fees, he says.

Although it's hard to confirm, investing experts believe that a disappointing stock market over the past decade has caused investors to scrutinize fees. "In a time when stock market returns are low, there appears to be more interest in expenses," says Standard & Poor's equity analyst Dylan Cathers, who helped develop S&P's mutual fund ranking methodology.

Brad Barber, a finance professor and expert on investor behavior at University of California, Davis, agrees. However, he says, the vast majority of investors choose funds based first on their past performance, and second on fees. Predicting future fund performance based on past returns is very difficult, as fund marketing materials point out. And research shows that the most expensive funds—those whose expenses rank in the top 20%—are actually the worst performers, Barber adds.

Generally, funds are divided into two starkly different categories: