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Home>Research & Insights>Investment Insights>Why Some Already High-Cost Funds Are Looking Even Pricier

Why Some Already High-Cost Funds Are Looking Even Pricier

With average fees falling, more funds should cut theirs, but too often they aren't.

Kevin McDevitt, CFA, 08/07/2017

My colleague Patricia Oey wrote a Fund Spy in May that summarized the latest Morningstar fee study for U.S. open-end mutual funds and exchange-traded funds. Two conclusions from the study should jump out at fund company executives.

First, the weighted-average fee that investors pay continues to fall, from 0.65% in 2013 to 0.57% in 2016. Second, investors continue to pull money from expensive funds (typically actively managed) and plow it into the cheapest funds, which are often passively managed. But even the weighted-average fee for active U.S. equity funds dropped to 0.77% from 0.83% during the same stretch.

So, investors are clearly more cost-conscious lately as they target cheaper funds, pushing weighted-average fees lower. It would seem that more-expensive funds would need to cut their expense ratios just to maintain their relative cost positions. It doesn't appear that this is happening--at least not to a sufficient degree.

Morningstar analysts rate more than 1,000 open-end mutual funds. During the past three years going back to 2014, there have been 217 changes to the Price Pillar rating--one of the five pillars that go into the overall Morningstar Analyst Rating--among the funds that Morningstar covers. Of these changes, 178 of them were downgrades (to Neutral from Positive, or to Negative from Neutral) and only 39 were upgrades; that's a ratio of 4.6 downgrades for every one upgrade. Clearly, many funds are becoming less cost-competitive as weighted-average expenses drop.

Errors of Omission and Commission
There are typically two possible reasons for such downgrades. As Warren Buffett might put it, think of them as errors of omission or errors of commission. First, let's look at errors of omission: in this case, not cutting expense ratios proactively to maintain relative cost competitiveness. That is, even though a fund's expense ratio may not have changed, its relative standing among its peers has likely deteriorated.

Take American Century Heritage TWHIX. As with the investor share class of many American Century equity funds, its expense ratio has long held firm at 1.00% of assets. In 2013, that was 11 basis points (or 0.11 percentage points) below the mid-cap no-load peer median. But since then, the median peer expense ratio has fallen 7 basis points to 1.04%. While American Century Heritage's 1.00% expense ratio is still 4 basis points below the median, it now falls in Morningstar's average fee range of 0.99%-1.12% for its peer group. Thus, its Price Pillar rating was cut to Neutral from Positive.

So, just keeping a fund's expense ratio stable is no longer sufficient for many funds. Given recent trends, it would seem much worse to actually increase a fund's expense ratio and raise its price--that is, to make an error of commission. But it happens.

Many actively managed funds are getting squeezed at both ends: They're confronted by increasing competition from low-cost funds, whether active or passive, while they're also contending with outflows as their clients flee to cheaper options. So just as they're facing stiff price competition, many advisors are forced to spread their costs--almost all of which are fixed in the short run--across a smaller asset base.

Kevin McDevitt is an Editorial Director with Morningstar.

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