Here's how mutual funds manage to charge outrageous fees -- and how you can avoid them. By Steven Goldberg, Contributing Columnist November 11, 2009 While investors, regulators and politicians have been gnashing their teeth over the misdeeds of assorted financial institutions and the shortcomings of some of their products and services, they’ve pretty much ignored mutual funds. But letting funds off scot-free is a mistake. In particular, fund sponsors, many of them large firms with billions of dollars under management, charge investors far too much -- and do so even when returns stink.For the overwhelming majority of funds, expenses ratios -- all annual costs as a percentage of assets -- are ridiculously high. For diversified domestic stock funds, for example, the average annual expense ratio is 1.31%. Take a look at even a fine product such as Fairholme Fund (symbol FAIRX), a member of the Kiplinger 25. The fund, which holds $10 billion in assets, charges 1.01% a year. Nearly all of that is for a 1.0%-per-year management fee. That fee brings in annual revenues of $100 million annually. How many first-rate analysts and consultants can Fairholme hire with $100 million? More than it can possibly need. How do funds manage to get away with such outrageous fees? Advertisement They don’t really behave like fiduciaries. The Investment Company Act of 1940, the basic law that governs mutual funds, makes it clear that a fund must be run for the benefit of its investors. The shareholders approve the board of directors, which has a fiduciary obligation to look out for your best interests. A fiduciary must place your interests above his or her own. The board’s most important duty is to hire the fund’s management. The board of Fidelity Magellan, for instance, is legally required to review the job that Fidelity has been doing. If Fidelity fails in its job or insists on being paid too much money, the board must fire Fidelity and hire another company -- say, Vanguard -- to run Magellan. But, of course, that almost never happens. They discount fees for big investors. In a Supreme Court case argued recently, fund shareholders claimed that Harris Associates, adviser to the Oakmark funds, had neglected its fiduciary duty. Exhibit A: As a percentage of assets, Harris charged a big institutional client about half as much as it did Oakmark Fund shareholders. The fact is, institutional investors generally won’t pay anywhere near the high fees mutual funds charge ordinary investors. Advertisement True, accounts of individual investors may cost more to service than one big institutional account. But that part of the expense ratio is generally broken out separately from the fund’s management fee, which goes to pay fund managers, analysts and traders. How could it possibly cost much more to manage money for small, individual investors than a big institutional investor? Beats me, but Harris told the Supreme Court that its management fees are fair. What’s more, the Supreme Court appears likely to rule in Harris’s favor. Boards of directors aren’t really independent. Half of mutual fund boards are required to be independent of the management company. They can’t be, say, officials of the company. But who picks the independent board members? The fund’s adviser picks all the initial board members. The independent directors pick succeeding independent directors. But boards, unfortunately, remain devoted primarily to fund management companies -- not shareholders. There’s an acid test to judge how independent boards are. Look at how often they’ve fired one adviser and hired a replacement. It’s incredibly rare. In 1992, Selected American Shares fired its manager, and in 2005 so did Clipper fund. I don’t know of any other instances in which the adviser was fired -- and the decision stuck. Advertisement They rely on consultants and averages. Fund boards often base their decisions about fees on the findings of consultants. Say, the board is looking at an intermediate national municipal bond fund that charges annual expenses of 0.70%. The consultant informs the board that the average such fund charges 0.75%. The board then votes unanimously to raise its expense ratio to 0.80%. After all, board members reason, their fund is certainly above average. So why shouldn’t it levy above-average expenses? Of course, that kind of action, repeated by thousands of fund boards, leads to the average expense ratio for such funds rising to 0.80% -- and, inevitably, higher. They hike expenses slowly. Massachusetts Investors Trust, the country’s first mutual fund, charged annual expenses of 0.33% in 1950. By 1960, assets had grown, so the fund lowered its expense ratio to 0.19%. The expense ratio on Massachusetts Investors Trust, part of MFS Investments, is now 0.89% -- almost triple what it was 60 years ago. That’s about par for the course, says Vanguard founder Jack Bogle, who now runs the independent Bogle Financial Markets Research Center. In 1960, the average stock fund charged 0.71% annually. Bogle calculates that the rate crept up over the decades to 1.44% today, including 12b-1 charges (which cover some marketing expenses, including broker commissions). Advertisement Annual fees aren’t all you pay for owning a mutual fund. You may also pay front-end sales charges and redemption fees. You pay brokerage commissions when a fund’s managers buy and sell stocks and bonds. More important and less understood, you pay “market impact costs” -- costs that result from a fund’s buying and selling of big blocks of stocks, bonds or other securities, usually pushing the price of those securities in the wrong direction. Estimates for these costs vary widely, but one study found that commissions and market-impact costs totaled 1.44% (coincidentally, the same as the average fund expense ratio) for the average domestic stock fund. (See Why Trading Costs Matter) What should you do about this state of affairs? The best course is to invest in low-cost funds. Academic studies have shown repeatedly that low expense ratios are predictive, on average, of relatively high returns. By operating its funds at cost, rather trying to turn a profit, Vanguard offers many of the best low-cost funds. If you use an adviser, favor the American funds, which charge almost as little as Vanguard (not counting the impact of their sales charges). And, of course, some funds, such as Fairholme, are worth their costs despite their high expenses ratios. Some exchange-traded funds charge even less than Vanguard and the American funds do. Vanguard’s own ETFs are often cheapest. ETFs under the iShares label boast low fees, too. Numerous ETFs, however, charge excessive fees, just like their mutual fund cousins. So, unless the Supreme Court rules against Harris Associates and its many supporters in the fund industry, the rule remains: Caveat Emptor. Steven T. Goldberg is an investment adviser.