Mutual Fund Costs are Declining

but are they keeping pace with the growth of the fund assets?

Early this week, Morningstar has an article which says that the costs of owning mutual funds are declining over the past 15 years. This is definitely good news for investors who use mutual funds as investment vehicle for their future. According to the article, Fund Fees Are Coming Down by Russel Kinnel, the expenses that investors paid for all funds have dropped from 0.97% in 1991 to 0.91% in 2006 (the changes in ERs of some major security categories are plotted in the figure below). Not an amount to get really excited about in 15 years.

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So what caused the ER to decline? The article says

The overwhelming driver of falling expense ratios is rising assets. A market rally led assets to appreciate and of course drew billions of dollars into funds. That meant many funds hit various fee breakpoints and expense ratios have come down.

That is, as the net assets of the fund grow, the fund manager will need a smaller percentage (ER) to draw the same amount of fees to cover the research and operating costs (see the definition of expense ratio at Investopedia). Thus, it’s fair to assume that the reduction in expense should keep pace with the growth of the fund’s net assets, even when inflation is factored in. But is that the case?

In the December 2006 issue of Financial Planning magazine, Craig L. Israelsen has a similar article, Economies of Scale?, that discussed the relationship between the fund’s assets and its expense ratio. As Mr. Israelsen pointed out in the article, the median net assets of 124 prominent US equity funds had grown from $0.28 billion in 1986 to $4.7 billion in 2005, a gain of a whopping 1587%.

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During the same time period, the author fund that the median expense ratio didn’t come down at all. Instead, it actually increased by 3.5%, from 0.85% in 1986 to 0.88% in 2005. The following plot shows the change of the asset-weighted ER (the annual expense ratio of a fund proportional to its annual share of the total assets of all funds combined together, similar to market-capitalization weighted equity indexes such as S&P 500 index) from 1986 to 2005, a decline of about 5.6% over the 20-year period, from 0.72% to 0.68%. Again, not even close to the scale of the growth of the fund’s assets.

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Therefore, while it’s good to see investors are getting some relief in investing in mutual funds, the fund companies still have a long way to go in bringing down the costs so that they will a stronger correlation with the fund’s assets.

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