Consistent returns and asset flows help explain why fund companies price bond funds cheaper than stock funds.
This article first appeared in the April/May 2011 issue of Morningstar Advisor magazine. Get your free subscription today!
Having spent years doing manager research at Morningstar, specializing in fixed-income managers, I have an appreciation for the level of sophistication that bond managers apply to their analysis.
Their research into credit quality, collateral status, cash flows, optionality embedded in some bonds, and legal provisions that envelope most fixed-income issues makes for a very complex exercise. And there are no exchanges for bonds, so trading is more difficult and involves more effort.
Therefore, I have to roll my eyes when I hear the argument that stock investing is more difficult than bond investing. Most people would agree that the bond departments of PIMCO, BlackRock, Western, and Fidelity are deep into some serious research. How many stock shops do the equivalent of recalculating the durations and option-adjusted spreads of every one of the thousands of bonds in the BarCap Aggregate Index every night?
Yet despite this sophistication, mutual fund firms charge less for fixed-income funds than they do for stock funds. According to Morning- star Direct, the average expense ratios for each Morningstar open-end category in the world's three biggest capital markets (the United States, Europe, and Japan) are remarkably consistent: Firms price equity funds higher than bond funds. Below are the averages for the three markets(1):
We have all heard about the equity premium puzzle, or why stock investors historically have been able to extract such a high return premium over bonds. But what about the equity fees premium puzzle? If the amount of time and effort that goes into managing bonds is the same as managing stocks, why do stock funds charge more?
I present three explanations. Two are straightforward answers, having to do with history and demand-side considerations. Both contain important elements of truth, but it's hard to see them as containing the full story. My third explanation, however, may complete the picture. It is meant to complement the other two, not supplant them, and present a new angle from which to consider the equity-fees puzzle.