Expense Ratios Continue to Fall

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Good news. The typical investor paid less in percentage terms for fund management in 2005 than in 2004. That's two years in a row that expense ratios have come down.

For this study, we looked at expense ratios as reported in annual reports for 2005. Although we're missing a handful of stragglers at this point, the final figures are unlikely to change our aggregate data by more than a basis point.

In most asset classes, the asset-weighted expense ratio came down four or five basis points. For example, the typical investor paid 0.93% in expenses for  a U.S.-stock fund in 2005 compared with 0.99% in 2004, excluding institutional share classes. Expenses for the typical investor in an international-stock fund fell from 1.17% to 1.1%.

By asset-weighting the figures (giving greater weight to big funds than small when calculating expense trends), we can figure out what the average investor paid. The trend toward slightly lower expenses was also at work in taxable-bond funds. The typical investor paid 0.85% for a taxable-bond fund in 2005 compared with 0.90% in 2004. However, municipal-bond fund expenses were steady at 0.74%, despite an increase in assets. As you may recall from our study last year, we found that investors were gravitating to funds with below-average costs in every broad asset class except munis. This may explain why the asset-weighted expenses for muni funds did not fall.

In dollar terms, the total amount fund investors paid in fees still increased last year. That's because most funds saw an overall increase in assets under management last year, so fund companies were charging fees on a larger base. That helps explain why, despite cutting expenses on many funds, the industry still produced record-setting revenues in 2005.

Nonetheless, the results of our study are encouraging when placed in the context of the long-term trend. In last year's study, we pointed out that although expenses fell in 2004, they were still at about the same level they were 15 years ago--despite a remarkable increase in assets over that time. However, another year's worth of expense cuts helped the industry to finally make some progress.