Equity investors are enjoying a race to the shallows of mutual fund expense ratios. At year end, Fidelity Investments lowered total net expenses on eight of its Spartan Index Funds. It also lowered the cost of entry for many smaller investors by dropping its minimum initial investment amount on 16 of its index funds and six enhanced index funds, by as much as $90,000.  

Vanguard Group, which drew $141.2 billion in cash flows last year, is widely considered a leader in lowering fund fees, a trend some trace to the late '90s. Since then, the average expense ratio for an equity index fund has sunk 13 basis points. Vanguard currently has assets of more than $2 trillion. But a list of the funds with the lowest expenses and the highest returns reveals that other competitors have gotten the message, too.

Vanguard, Fidelity and Columbia Management Investment all scored two funds each out of a list of 10 equity mutual funds with the highest three-year average annual returns, generated by mutual fund database Morningstar, which filtered out all but funds with expense ratios of .50 or below.

Leading the pack, as of December 31, 2012, was Vanguard REIT Index Signal (VGRSX), which delivered a handsome average annual return over three years of 17.976 percent on expenses of just 0.100 percent. Following was ING Corporate Leaders Trust Series B with 15.479 percent and a 0.490 percent fee that just cleared the goal. The fund is unusual among index funds: It was created in 1935 with an equal number of common stock shares of the 30 leading U.S. companies at the time. New stocks can’t be purchased, so there are only 22 holdings remaining now.

Expenses dropped back down again for the Columbia Small Cap Index Z (NMSCX), which is capped at just 0.200 percent, with a return of 13.864 percent. Columbia's sister fund of A shares (NMSAX), no. 7 on the list, returned an average 13.602 percent with expenses of 0.450 percent. The funds are managed by Columbia Management Investment Advisers and track the S&P Small Cap 600 Index.

No. 4 on the list is the Dreyfus Small Cap Stock Index (DISSX), which just made the FA-Mag cutoff at .490 percent, while still gaining a respectable 13.814 percent return.

Next was the other Vanguard, the Small Cap Index Signal (VSISX), weighing in with the same expense ratio, of 0.100 percent, while delivering a 13.738 percent return, four points lower than its sister. We shouldn't be too quick to draw distinctions between real estate and small-cap holdings though, cautions James Holtzman, CFP, CPA, wealth manager and shareholder in the Pittsburgh-based Legend Financial Advisors Inc. Some REITs aren't performing in a negatively correlated way as they have in the past, he says, moving instead more in tandem with equity markets.

In the 2002 period, Holtzman says, REITS “were terrific. But in recent downturns, like 2008, they haven't done as well” at offsetting market losses. This is probably because more REITs have moved away from core real estate holdings, such as VGRSX's large share holding in a traded storage company. Companies like storage facility owners are more closely linked to the general economy than more traditional REIT holdings. So if you're looking for a low-expense ratio and good return, fine. But REITS aren't the cushions against market turmoil they once were, he says.

Even with passive funds, Holtzman says, he’d want to know how the stocks are replaced before he'd recommend one to a client. Indexed doesn't always mean not managed, he notes. And, knowing the process the manager is using to replace the holdings can explain an expense ratio higher than one an advisor might expect for a passive fund.

The only large growth fund on the list, Shelton Nasdaq-100 Index Direct (NASDX) enjoyed a 13.703 percent three-year return for a 0.49 percent expense fee. The fund loves Apple and has a 60 percent concentration in the technology sector. It is owned by Shelton Capital Management and managed by its CEO.

T Rowe Price is another mutual fund family that emphasizes low costs. Its Extended Equity Market Index fund (PEXMX) is a mid-cap blend that averaged 13.484 percent with no load and an expense ratio of 0.400 percent.

Two Fidelity Spartan funds round out the list of 10. The Extended Market Index Advantage (FSEVX) delivered 13.464 percent for a super low 0.070 percent ratio, and Market Extended Index Investor class (FSEMX), earned only slightly less return, 13.430 percent, at a still low 0.100 percent expense rate. The initial investment for the investor class fund is now $2,500.

Clients are “pretty sensitive to expense ratios,” especially in the five years since market returns have been poor, says Holtzman. “But, you can't look at expense ratios in a vacuum.” A new fund may have higher fees, because it hasn't attracted sufficient assets  with which to spread its costs among. But it can also be more nimble and able to take advantage of a sudden opportunity in the market.

The top 10, based on three-year average annual returns:
1. Vanguard REIT Index Signal
2. ING Corporate Leaders
3. Columbia Small Cap Z Shares
4. Dreyfus Small Cap Stock Index
5. Vanguard Small Cap Index Signal
6. Shelton Nasdaq-100 Index Direct
7. Columbia Small Cap A
8. T. Rowe Price Extended Equity Market Index
9. Fidelity Extended Market Index Advantage
10. Fidelity Extended Market Index Investor