Low Fees Alone Don't Make a Fund a Buy

During that time, though, lowly index funds kept chugging along like they usually do. These funds tend to keep a low profile, especially when other parts of the investing world are either throwing up big numbers or hitting the skids hard. Not that index offerings have been able to escape the recent downturn. Lipper says the average S&P 500 fund is down 5% in 2008. However, they make dealing with dismal performance a little less painful. Since index funds don't have to pay managers big bucks to buy and sell stocks they can pass those cost savings along to shareholders in the form of the industry's lowest annual fees.

Index funds take center stage on this week's screen that focuses on cheap fees. But they weren't the only types of offerings to make our final cut. Instead of looking strictly at the lowest absolute expense ratios — a tactic that would've produced a list top-heavy with index funds — we decided to screen for funds that charged fees that were in the lowest 15% of their respective categories. That way we would find the index funds that charge bargain-basement fees along with the cheapest health-care, small-cap and growth funds, too. After adding in our usual performance criteria we were left with an initial list of 62 funds. We tightened our criteria to get that group down to a manageable 13 names.

Usually a spot on our list implies a stamp of approval. This week, though, we aren't suggesting that all these funds are good buys. That's because fees shouldn't be the singular reason for scooping up the shares of a certain fund. We looked at returns, too. However, smart investors also need to be cognizant of timing. Do people who consider themselves conservative need to be jumping into a financial-services fund right now simply because its fees are less than most of its competitors? Probably not.

Investors are attracted to low-fee funds because of their most glaring attribute: They save money over the long haul. Indeed, let's say you deposit a hypothetical $10,000 worth of college graduation money in a low-cost equity fund and leave it there until you retire at 65. And, for the sake of argument, let's say the fund averages an annual 10% return during that time. If the fund charged a 0.5% expense ratio — $50 per year for every $10,000 — that pot of money would grow to around $485,000 at the end of that time period. If the fund had charged a 1.0% fee, you would've lost out on almost $100,000. And if the fund had levied an initial 5.25% front-end load you would've kissed another $20,000 goodbye. Now, this example doesn't take into account a myriad of things that can happen to an investing account over its lifetime. It does show, though, that over time fees can have a profound effect on your balance.

That's one of the reasons why we lifted our usual minimum investment cutoff of $5,000. Fund families like Fidelity and Vanguard will shave basis points off their already low expense ratios if investors move $100,000 into some of their offerings. (The $100,000 share class at Vanguard is called Admiral; at Fidelity it's referred to as Advantage.) The difference between paying $15 a year on a $10,000 investment in, say, the Vanguard Total Stock Market index fund (VTSMX) and $7 a year on a $100,000 investment in that same fund, may not sound like a huge difference. Do the math, though, using this simple SEC calculator. You'll see that even that small difference adds up over long periods of time.

Of course, there are some drawbacks to low fees. The money that's generated by expense ratios, regardless of how big or small they are, keep a fund family in business. Watch for a firm that drops its fees without a legitimate reason. It could be a simple ploy to attract assets that would bolster its bottom line. Also, studies have shown funds that bulge in size risk sacrificing returns because a manager has more difficulty buying stocks without single-handedly popping the price. And don't forget about small shops or good managers. Sometimes it can be a wise move to pay up for hand-holding or for the expertise of a given manager. After all, a fund's absolute return is really what matters at the end of the day.

"Vanguard has done a fantastic job at keeping fees low for cookie-cutter index funds and sometimes that is best [for investors]," says Bill Wixon, president of Wixon Advisors in Maple Grove, Minn. However, he thinks actively managed funds and asset allocation are the better bet. "As long as we continue to knock the snot out of indexes we won't buy them."

The list below contains an eclectic collection of funds. From its inception in 1995 through the first quarter of this year, the T. Rowe Price Health Sciences fund (PRHSX) has returned an average annual 12.7%. It charges a low $83 for every $10,000 invested. CGM Realty (CGMRX) is a fund that can make its shareholders forget about their annual fees, even if they are low. The last year it has returned a remarkable 32% thanks to some strategic commodity-type bets. Holding down a spot on our list once again is the Vanguard 500 (VFIAX). It has returned 11.6% since its inception in 1976. The Admiral share class charges a 0.07% annual expense ratio. There aren't many funds that beat that rock-bottom fee.

The Criteria
We screened our Lipper mutual fund database for equity funds whose expense ratios were in the bottom 15% of their respective classifications. The funds had to be open to new money and they also could not charge a load. We lifted our minimum investment criteria since some fund families offer discount rates for shareholders who deposit more than $100,000. Finally, the funds below were in the top 10% of their categories over the trailing three- and five-year time periods. Target-date funds were eliminated since they get their own screens throughout the course of the year.