The Real Fund Rip-Off

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Midnight trading. Hush-hush commissions. Corrupt executives. The recent torrent of headlines about mutual-fund scandals provides ample cause for outrage among investors. But if you're wondering how badly the industry's shenanigans have damaged your wallet, the answer is, probably not much. A Stanford University study found that overnight arbitraging in funds cost investors more than $4 billion a year. That's hardly a drop in the bucket, but it was widely diluted in a fund industry with $7 trillion in assets under management.

In fact, the far more consequential — but perfectly legal — rip-off is the bevy of bloated fees that fund firms charge to manage your money. These range from loads (hefty commissions doled out to brokers or financial advisers for selling you a fund) to fees that cover advertising, marketing and distribution costs for the funds (known as 12b-1 fees). In Senate hearings earlier this month, New York State attorney general Eliot Spitzer said inflated fees may be costing investors $10 billion a year.

Of course, fund companies have every right to charge for their services. Fund managers need to eat too. But many investors don't fully grasp what they're paying for and why. In a poll by MONEY magazine and the Vanguard fund group, only a quarter of those in the survey realized that the "expense ratio" is an annual fee deducted from a fund's earnings — and that it lowers shareholders' returns.

Loads can be particularly baffling. If you invest through a broker instead of directly through the fund company, you probably pay a load. To buy Class A shares, you often pay as much as 5% of your money up front before the fund company buys any stocks for you. Class B shares skip the up-front fee, but add an extra average fee of 1% annually and hit you with hefty fines if you cash out early, which proves more costly in the long run. "The whole idea of B shares," says Max Rottersman, founder of FundExpenses.com, which tracks mutual-fund fees and costs, "is to get idiots into funds."

Washington may require fund companies to disclose fees and expenses to investors more clearly. But investors can take action on their own by carefully reading a fund's prospectus before they invest or by checking out the expenses through research services like Morningstar.com. The simplest solution, however, is to avoid commissions altogether by choosing from the 5,500 or so no-load funds of such firms as Vanguard, Fidelity and T. Rowe Price. No-load funds levy no sales commissions and charge only modest 12b-1 fees. But no-load funds have costs too, so look for those that impose expense ratios of less than 1% a year. Remember: when it comes to funds, you can't afford to take anything on trust alone.