Suze Orman Money Matters

The Securities and Exchange Commission recently held a big get-together to debate the current state of mutual fund 12b-1 fee disclosure. That's the marketing fee charged by many -- but not all -- mutual funds buried within the fund's annual expense ratio.

Little Awareness, Big Profit

Because it's not a line-item fee on fund statements, many people have no idea whether they pay a 12b-1 fee or not. That's a costly lack of awareness: the Investment Company Institute (ICI) estimates that fund companies collected $11.8 billion on this fee alone in 2006.

The main use of the 12b-1 is for fund companies to compensate brokers and advisers who steer clients into these funds. Because it's an ongoing fee that's merely a component of the annual expense ratio rather than an outright sales load, it's become popular with advisers as a means of telling clients that they're investing without paying a sales load.

This pitch is technically correct, in that there's no upfront sales charge, but it's nonetheless a bit disingenuous. The expense ratio is bloated by the 12b-1 fee, which is then used to funnel a commission back to the adviser. The fee can be 1 percent or even more. And the fee is levied on every investor every year they're in a 12b-1 fund.

A Long-term Disclosure Gap

I don't need to explain what a lousy deal this is for consumers. As I wrote in my previous column, it's fine if you want to work with a financial adviser. But if you're already paying them a fee to handle your money, why would you also agree to invest in mutual funds that charge a big expense ratio in large part to send more compensation your adviser's way?

It's a no-brainer that fund companies should be required to make the 12b-1 fee more transparent to investors, but I'm not holding my breath until the fund industry or regulators step up. Lousy disclosure has been around since the 12b-1 came into existence more than 25 years ago.

I'm more interested in what investors can do right now to avoid this costly fee. It's remarkably easy to build either a mutual fund or exchange traded fund (ETF) portfolio that's 100 percent free of 12b-1 fees. By steering clear of funds with high annual expense ratios, you keep precious dollars growing in your account.

A Revealing Comparison

As an example, let's compare two funds: A no-load index fund that doesn't charge a 12b-1 fee and has an expense ratio of 0.19 percent, and a mutual fund that has a 12b-1 fee that pushes the total expense ratio up to 1.5 percent.

If both funds earn a gross (pre-expense) annualized return of 8 percent, the index fund's net return, after the expense ratio is deducted, is 7.81 percent; the mutual fund's gain is shaved to 6.5 percent.

In the investing world, that's a huge difference. Consider that $10,000 invested in the low-expense-ratio fund will grow to nearly $45,000 after 20 years, and only to around $35,000 in the fund with the higher expense ratio.

The ETF Advantage

If you opt for ETFs, you can push your fees even lower.

In case some of you need a refresher course, an ETF is very similar to your standard index mutual fund except for one major difference: it trades on a stock exchange just like a stock. This means that during the trading day, you can get a price to buy or sell based on the market value of the underlying securities in the ETF.

With a mutual fund you can always place an order during the trading day, but mutual fund prices are calculated just once a day, at the market close. There are also some structural differences between index funds and ETFs that can make ETFs a more tax-efficient choice.

But one of the most compelling ETF advantages are expense ratios that can be under 0.10 percent. True, 0.19 percent for an index fund is already pretty great, but 0.07 percent or even 0.10 percent is even better.

Room for Improvement

That said, index funds can be more cost-effective if you make frequent periodic investments. A no-load index fund doesn't charge any sales commission, but because ETFs are essentially stocks, there's always a brokerage commission charged on your buy and sell orders. Even if you use a discount brokerage and pay just $10 or so for ETF trades, that can add up if you invest smaller amounts every few weeks.

Still, the overall cost advantage is a big reason that ETF assets have increased more than 44 percent over the 12 months through May 2007, according to ICI data. But while it's great that investors are finally catching on that expenses do matter, the $485 billion in ETF assets is still just a fraction of the $11.4 trillion invested in mutual funds.

I'd be fine with this if I was certain that the bulk of that money was in the lowest-cost options. The $11.8 billion paid out in 12b-1 fees last year, however, tells me there's still plenty of room for fund investors to get their costs down.

Give Your Portfolio a Fee Exam

Finding the expense ratio for your investments is just a few clicks away. Just enter a fund or ETF ticker symbol in the Yahoo! Finance "Get Quotes" box, then click "Profile" on the left side of the page that appears. A fee and expense table appears in the lower right of the next page. To see the expense ratios of all ETFs from lowest to highest, click here.

So what's a "good" expense ratio? If you're investing in a broad large-cap index, there are plenty of good options that charge less than 0.20 percent; international indexes and ETFs tend to be a bit more expensive, but that means maybe 0.40 percent to 0.50 percent. That's still a whole lot less than the 1 percent to 1.5 percent or more many actively managed mutual funds charge.

Of course, if you feel that the manager of that fund is so good that he or she is worth the extra expense, that's a conscious fee decision you need to make. But the operative word is "conscious."

Be Fee-Aware

If you're aware of the higher fee and think it's justified, that's your choice. But I think in many cases once you understand your fund's fee structure and compare its performance to what you could get in a low-cost index fund or ETF, you'll be hard pressed to justify sticking with the expensive option.

Finally, if you're stuck with high-cost funds through your employer's 401(k) or 403(b) plan, I suggest you get a bunch of colleagues together and start besieging HR with requests to change the plan's funds.

Don't be timid: A 401(k) is supposed to be run for the benefit of the participants -- that's you. There's no way to justify that high-fee funds are a benefit to anyone.