Don’t Pay High Fees for Index Funds

May 3, 2013, 6:05 p.m. ET

Don’t Pay High Fees for Index Funds

By JOE LIGHT

You might think that a plain-vanilla index mutual fund is synonymous with low fees. But some such funds are charging expenses that might make even a high-turnover momentum-fund manager blush.

The indexing revolution has been a boon for investors. Big fund companies have launched many nearly identical mutual funds and exchange-traded funds that track indexes such as the Standard & Poor’s 500. With nothing to compete on but price, that’s meant ever lower expenses for investors.

According to an April report from the Investment Company Institute, a trade group, stock-fund investors on average paid 0.77% in expenses in 2012, or $77 per $10,000 invested. That was down from 0.79% in 2011 and from 1% a decade ago.A big part of that change has been the rise of passively managed mutual funds and ETFs. For example, the Vanguard 500 Index Fund charges merely 0.05% a year—or $5 for every $10,000 invested—if you have at least $10,000 to invest.

Yet some companies that run S&P 500-tracking index funds apparently haven’t gotten the memo. More than two dozen such funds have a share class that charges at least 10 times as much as Vanguard Group does. A handful charge more than 1% annually, or more than 20 times as much, according to investment researcherMorningstar MORN +2.14% .

“It’s embarrassing to have them out there,” says Rick Ferri of investment manager Portfolio Solutions in Troy, Mich. “Some investors are really getting ripped off, without a doubt.”

The sharp differences in fees highlight the need for investors to be vigilant about whether their index fund is actually a good deal, especially if they use an adviser who gets a commission from picking an expensive fund.

Take the Rydex S&P 500 mutual fund, which, like Vanguard’s fund, simply seeks to replicate the returns of the S&P 500. But to do so, Guggenheim Investments, which runs the fund, charges a whopping 1.51% in annual expenses in one of its share classes. About 0.25% goes to “12b-1” fees, which often go to financial advisers who put their clients into it.

Just to get into the Rydex fund, new investors must pay an upfront commission, or “load,” of 4.75% of their total investment, or $4,750 on a $100,000 investment.

To put that in perspective, someone who five years ago invested $100,000 in the Vanguard fund would now have about $126,000. Someone who invested in the Rydex fund would have $111,000, including the upfront commission.

Rydex isn’t alone. The “investor” share class of the ProFunds Bull fund, which is run by ProShares and tracks the S&P 500, charges 1.72% annually. Other companies with S&P 500 funds that cost more than 0.5% include State Farm, Federated Investors, Principal Funds and Wells Fargo WFC +0.88% . Collectively, the share classes of S&P 500 funds that charge more than 0.5% have $11.6 billion under management.

Some of the funds appear in 401(k) plans or are sold through financial advisers, and part of their expenses pay for costs to administer the plan or compensate advisers.

Guggenheim Managing Director William Belden says that most investors and advisers who use the firm’s S&P 500 fund also use other Rydex products and find it convenient to stay within the Rydex fund family. He says that most investors only temporarily keep money in the S&P 500 fund.

“Fees are very much a consideration for us and our board,” he says.

Through a spokesman, ProShares managing director Steve Cohen says he believes ProFunds investors think it’s worth paying a high expense ratio for the ability to move in and out of the fund without restrictions or transaction fees.

There might be another reason people put up with these fees. Some investors might not understand how index funds work, says Yale University finance professor James Choi.

Prof. Choi in 2010 published an experiment in which Wharton School M.B.A. students were asked to allocate money among four mutual funds, each of which simply tracked the S&P 500.

The funds debuted in different years, so they had different performance records depending on when they launched. The funds also charged different expense ratios.

Rather than choose the fund with the lowest expenses, most students spread money between multiple funds, with many homing in on funds with the highest past returns.

“I was skeptical that I’d find anything interesting because the task seemed so easy,” says Prof. Choi. “I guess in any market where there are fools, it’s profitable to make a bad product and pick up a few.”

Prof. Choi later ran a similar experiment using Harvard University staff. They also failed to pick the cheapest fund, and in a survey after the experiment listed fees as the fifth most important factor in making their decision, behind performance.

Another factor: inertia.

Many high-fee index funds launched during the 1990s stock boom, says Ali Hortaçsu, an economics professor at the University of Chicago, who has studied the phenomenon.

After gathering hundreds of millions of dollars, the funds stopped marketing and never bothered to bring down their fees while the rest of the fund industry competed for new cash, he says.

It’s easy enough to avoid falling victim to high index-fund fees yourself.

Ask your adviser for your funds’ prospectuses and look for the funds’ expense ratios. The portion of the ratio that’s labeled a 12b-1 fee might go to your adviser, while the rest goes to managing the fund and other expenses.

Then, compare the expense ratio to the chart of index funds on this page, each of which is among the cheapest for the index it tracks, according to Morningstar.

Since index fund fees are continuing to drop, check regularly to ensure you’re not falling far behind the fee leader.

“You care about prices in the supermarket,” says Prof. Hortaçsu. “You should care about investment expenses too.”