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Mutual Fund Fees & Expense Waivers

I’ve written before about the importance of reading a mutual fund prospectus. Just the other day as I was researching my article on low-cost, socially responsible investment options, I experienced a perfect example of why it’s so important.

According to the fund list I found, Pax World Investments’ Pax World International Fund was the lowest cost “socially responsible” international equity fund, with an expense ratio of 1.40%. But before suggesting it on the blog, I thought it would be wise to download and read the prospectus.

If you flip to page 40 (Fees & Expenses), you’ll see the real costs of running the fund. The total? 11.82% of assets! (Seriously. Go look.)

So how was it that a 1.40% expense ratio was listed elsewhere? As happens frequently in the mutual fund industry, the management company waived a portion of the expenses (in this case, almost 90% of the expenses).

The catch is that this waiver of fees isn’t permanent. In this case, it’s through 12/31/2012, but in many cases, the management company can discontinue it at any time.

Loss Leaders

Some fund companies run certain funds at a loss on an ongoing basis. For example, Schwab’s S&P 500 Index Fund only charges shareholders an expense ratio of 0.09% per year, when its gross expense ratio is 0.21%.

My understanding is that their purpose for this fund is much the same as that of milk at the grocery store: sell it at a small loss in order to bring in customers, to whom they can sell more profitable products (like higher cost, actively managed funds).

The existence of a fee waiver wouldn’t bother me much if I were pondering investing in one of Schwab’s index funds. In those cases, even if the waiver disappeared, it wouldn’t be that big of a deal as long as you noticed it within a couple years and switched to a lower cost fund. (Note: This would mean continuing to read prospectuses from time to time, even after investing in the funds.)

But that’s one big waiver!

But in the case of the Pax World International Fund, we’re not talking about a 0.12% jump in expenses if/when the waiver disappears. We’re talking about an increase in expenses equal to more than 10% of fund assets. I don’t know about you, but that would make me extremely hesitant to invest in the fund.

The Lesson: Read the prospectus

Assuming you plan to own a fund for several years, you need to know not only what its expenses are now, but what they’re likely to change to in the future. That’s the kind of information that you’ll only find in a prospectus.

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  1. This is so important. Those fees suck up any potential gain you may get from your investment. The worst part is the sneakiness and unfortunately that is how much of the industry works.

  2. Mike,

    Good stuff, this one and the prior on socially responsible funds.

    I made a point of reading the prospectus for the funds I’ve invested in. OK, by “read” I mean “skim.” However, there is no way I’d invest in anything if I thought I needed to read the prospectus year after year. Forget it. And most folks don’t read the prospectus at all. I can’t say as I blame them. It isn’t easy if you don’t know what to look for.

    That all leads me to the following advice: It is, perhaps, safer for non-prospectus reading investors to take a well-travelled path of low-cost investing. Skip all the fancy, exotic stuff. Skip the fringe stuff (like socially responsible investing). You could lose your shirt on those with high fees you don’t notice. Just go with Vanguard index funds (or similar). If Vanguard ever tried to slip a big fee past investors it would be big news. Anyone reading this blog would know about it.

  3. Let’s not forget that the published expense ratio is only part of the story. Mutual funds incur other costs, such as transaction costs within the fund. In actively managed funds, those costs can double or triple the expenses found in the prospectus, and waivers don’t cover those costs.

  4. TDG: The sneakiness is indeed the worst part. It amazes me how pretty much everyday at the Bogleheads forum there is a post by somebody who is trying (and not succeeding!) to figure out what his/her total investment costs are.

    TIE: My approach is similar. Stick with funds where I know what I own.

    Dylan: You raise a good point. By the way, I’m including that white paper you sent regarding the “all in” costs of fund ownership in my roundup tomorrow.

  5. Is there a website that lists the potential expense ratio, or is the prospectus the only place to find it?

  6. Mike – interesting topic.

    I wonder if you considered how this concept of fee waivers might get disrupted if you are incredibly successful in your goal of converting the huddled masses to the usage of passive investment funds? 😀

    If the actively managed funds no longer get purchased by investors, then the revenue for these management firms would have to come from passively managed funds – which may then require that the fee waiver to be dropped (to maintain profits), thus decreasing one of the perks of the passive fund. :p

  7. Jeremy: If you google the ticker symbol of a given fund plus “expense ratio” you’ll generally get a morningstar or yahoo finance page showing the expense ratio.

    Still, it can be a good idea to check the prospectus if you’re concerned about hidden surprises like temporarily waived fees.

    Dave: One can only dream…. 😉

  8. Mike – You make a good point, but I won’t be too worried about this particular Pax World fund. It’s a new fund, only started in May 2008. It’s a small fund, with less than $4 million in assets. When you have a new, small fund, the start up cost, which is probably one-time, can be huge relative to the fund asset. 10.57% of that 11.84% expense ratio was “Other.” With a management fee of 0.85% and a 0.25% 12b-1 fee, I can see the fund’s expense ratio won’t be too far above the 1.40% expense waiver level when it reaches the steady state.

  9. TFB: Yeah, my point wasn’t so much that I’d expect its ER to skyrocket upward promptly upon 12/31/2012.

    Rather, I think it’s important to look and see what the actual expenses of running the fund are. While I wouldn’t necessarily say “don’t invest in this fund,” I’d still suggest that any potential investors take the time to keep an eye on the expense information published in its prospectuses going forward–making sure that the expenses are actually coming down toward the expected 1.40% level.

  10. I’m slowly learning these things now. I read a similar post at JD’s blog about reading the prospectus and how to read one (I’m sure you might have seen this already)
    I am making it a point to go back and study the prospectuses of the two funds I am currently investing in right now. I had overlooked it before as I thought the summary on the website was good enough.
    Thanks for pointing this out again.

    P.S. How often do prospectus(es) change?

  11. Hi Damilola.

    I like to think of a prospectus as an owner’s manual–good to check back through every once in a while even after making the purchase.

    Fund prospectuses must be updated at least annually.

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