An explosion in the number of funds and share classes has yielded few economies of scale for investors.
In building portfolios for clients, one of the choices we have to make is vehicle—mutual funds, exchange-traded funds, or individual securities. In making that decision, we want to feel confident that our clients will not only pay a fair price but share in economies of scale as time wears on.
A number of recent studies have examined trends in mutual fund expense ratios. Several of these studies, however, have assessed the change in asset-weighted expenses, an approach that we think conflates the issue of what the industry has done to economize mutual fund investing and what choices investors have made given the options presented to them. Therefore, we want to evaluate the change in average mutual fund expenses over the past two decades.
We compiled expense ratio data for all share classes of every U.S. open-end mutual fund that existed from 1990 through 2011. Our study included funds that were merged or liquidated away, so as to remove survivorship bias, but excluded fund-of-funds to prevent double-counting. We examined more than 33,900 distinct fund share classes. To ensure accuracy, we used each mutual fund’s audited net annual expense ratio, which is listed in the annual report it files with the Securities and Exchange Commission.
We commenced the study in 1990 for a few reasons. First, there was a critical mass of funds in that year, making the data we compiled meaningful in aggregate. Second, it roughly approximated the beginning of a dramatic growth spurt for the fund industry, making it a logical point of comparison.
We found that the cost of the average fund rose over the 22-year period. The average expense ratio of all funds rose to 1.29% from 1.18% from 1990 through 2011. This span, however, encompasses two distinct eras. An “inflationary” era spanned 1990 through 2000, when the average expense ratio rose 21 basis points to 1.39%. A “deflationary” period occurred in 2001 through 2011, when the ave- rage expense ratio fell 10 basis points to 1.29%.
When we break down the data by asset class, we find more or less the same trend, though the magnitude varied. For example, the cost of the average foreign-stock fund climbed 11 basis points from 1990 through 2000, but then dropped 32 basis points over the subsequent 11 years. Thus, foreign-stock funds got cheaper, on average, over the full study period. By contrast, the average expense ratio of municipal-bond funds jumped a startling 36 basis points from 1990 through 2000, but retraced only 10 basis points of those gains in recent years, explaining why the average price tag of such funds rose. All told, the average expense ratio fell in four of the six asset classes over the 22-year study period.
Why Expenses Rose
The overall average expense ratio of funds rose for three interrelated reasons.
First, the mix of funds shifted from lower-cost bond and balanced funds to pricier stock funds, which now dominate in sheer numbers. U.S. stock and foreign funds accounted for around 44% of all funds (including multiple share classes) in 1990; they accounted for 61% in 2011. Thus, while the cost of U.S. and foreign equity funds fell during the study period, they came to outnumber cheaper bond and balanced funds, raising the average expense ratio of all funds in the process.