June 4, 2003 — Annual operating expenses are a key factor to consider before investing in any kind of mutual fund, but the information is particularly important when choosing a bond fund, industry observers say.

Operating expenses, or expense ratios, represent a percentage of a fund’s average net assets and are taken out of the fund before its daily closing price is calculated. Because of that, a fund with low expenses may generate better returns than one with high expenses.

Low expenses are especially preferable in bond funds because their returns tend to be lower than those of stock funds to begin with, says Gary Arne, a managing director with Standard & Poor’s who follows fixed-income funds for its Fund Advisor service.

“I would think that, in most cases, bond funds with similar holdings or similar (investment) objectives that have higher expense ratios are going to have lower returns” than those that keep costs down, Arne says. “Obviously, with any expense ratio, you want to make sure you’re paying, I would assume, somewhere near the norm for that type of bond fund,” he adds.

Standard & Poor’s data showed that through April this year, the expense ratios for funds that invested in taxable U.S. bonds averaged 1.05%; the average for tax-exempt domestic bond funds was a virtually identical 1.06%. Also, the 77 funds that carried Standard & Poor’s highest ranking of 5 Stars had an average expense ratio of 0.82%. The average for the 5-Star funds that invest in taxable domestic bonds was 0.94%, while tax-exempt funds averaged 0.58%.

Among major fund companies, bond funds offered by the Vanguard Group had an average expense ratio of 0.20%. The company, the second largest U.S. fund complex in terms of assets under management, is owned by its fund shareholders, a structure which helps it keep costs in check. The firm oversees about $220 billion in fixed-income funds.

By comparison, the No. 1 fund complex, Fidelity Investments, has an average expense ratio of 0.77% on its fixed-income funds. Within that group, Fidelity’s Spartan funds have average expenses of 0.45%, and its Advisor funds sport an average 0.89% expense ratio.

The expense ratio itself includes advisory fees paid to fund managers; administrative costs like record keeping, printing and postage; and distribution and service, or 12b-1, fees, which cover marketing and distribution costs.

Higher expenses are not an indication of superior fund management. In addition, Brian Mattes, a Vanguard principal and spokesman, says there is no evidence that expensive bond funds outperform cheap ones over the long term.

However, costlier funds may sometimes come out on top in the near term, according to Mattes. “Over short periods of time, it’s possible, for a variety of reasons, most of them having to do with anomalies, or just luck, or some quirk in the market place,” he says.

One way bond fund managers may be tempted to try to overcome the effects of high expenses is by lowering the credit quality of their portfolios, Mattes says. But this makes the fund more risky, he notes.

Low expenses can loom larger in a bond fund’s returns in periods when interest rates are low.

“It’s a simple fact of life,” Mattes said of the effect of expenses on a fund’s performance. “Everyone in the market must get whatever the market’s return is before expenses, and once you add in expenses, you’re not going to get the market’s return.”