When it comes to mutual funds, you could be looking for love in all the wrong places according to the renowned bond fund manager, Bill Gross. In his August 2009 Investment Outlook, Gross compared his own industry to Madame Rue, the gold-toothed gypsy in the 1959 song “Love Potion No. 9.”

Gross argues that mutual fund managers sell potion in the form of hope. But when it comes to delivering on performance, they fall short — once their hefty management fees are siphoned out of the funds’ returns.

The average annual fee for an equity mutual fund is about 1%. That doesn’t sound like much when the market is up nearly +16%, as it was in 2006. And maybe the fees were just more salt in the wound after last year’s -37% slide. But for many individual years — and over the market’s long haul — that seemingly insignificant annual fee robs investors of substantial profits.

Gross wrote, “If investment returns gravitate close to 6% as envisaged in Pimco’s ‘new normal,’ then 15% of your income will be extracted [through management fees].”

Losing 15% of your profits to mutual fund fees may be an understatement.

Consider:

• 2,681 U.S. mutual funds have management fees that are double the average fee — or higher.

• The S&P 500’s annual total return has been less than +6% for 18 years since 1960.

• In the last ten years, the S&P 500’s average annual return has been flat. Fees would have pushed an investor’s return negative.

#-ad_banner-#Mutual funds spent more than 50 years as the only way investors could easily access a diverse basket of stocks with just one purchase. They had to pay hefty fees for the privilege. But since 1993, investors have had another choice to add diversity to their portfolios, and one that’s far cheaper,. Exchange-Traded Funds, or ETFs, are as easy to trade as stocks and offer the diversification of mutual funds, yet they have much lower fees. More than 800 ETFs trade on U.S. exchanges, each offering investors a cost-effective way to acquire a basket of securities. ETFs provide exposure to almost every country, region, industrial sector or commodity.

Results are the best way to see the real power of ETFs. I compared the returns of two similar emerging-market funds. One is the mutual fund Seligman Emerging Markets (SHEBX); the other is the ETF iShares MSCI Emerging Markets Index (NYSE: EEM). Not only does each have exposure to the same countries, each fund holds almost exactly the same stocks.

I used the Financial Industry Regulatory Authority’s handy fund analyzer (found here). I used a $10,000 initial investment and assumed that both funds returned +5% a year.

As you can see, the higher fees associated with the mutual fund would have sucked up more than half the gains. And here’s the real kicker: The mutual fund collected more in fees than the investor made in profits!

The last thing you want to do — in good times or bad — is give your hard-earned money to Madame Rue. If you’re still holding mutual funds with fees of 1% or greater, now is the time to look into ETFs.