Investors have been voting with their feet for low-cost funds, bringing down average fees again in 2016.
This is an excerpt from our recently released research paper on U.S. fund fees. The full paper is available here.
Morningstar's study of U.S. open-end mutual funds and exchange-traded funds finds that, on average, investors paid lower fund expenses in 2016 than ever before. The asset-weighted average expense ratio across funds (excluding money market funds and funds of funds) was 0.57% in 2016, down from 0.61% in 2015 and 0.65% three years ago. This decline stems from strong investor demand for lower-cost funds, principally passive funds and institutional share classes that carry lower fees. This is a positive trend, as mutual fund costs have a dollar-for-dollar impact on the returns investors ultimately realize.
Our study found that the simple average expense ratio of the largest 2,000 funds (in 2013), which accounted for 85% of assets in mutual funds and ETFs, was 0.72% in 2016, unchanged from 2015 and 2014. So on average, the fund industry is not cutting fees on the most widely held funds, which means the decline in average mutual fund fees paid by investors stems largely from investors' migration to lower-cost funds.
In this study, we used the asset-weighted average expense ratio instead of a simple average, or equal-weighted average, expense ratio. We feel an asset-weighted average is a better measure of the average cost borne by investors than a simple average, which can be skewed by a few outliers, such as high-cost funds that have low asset levels. In 2016, the simple average expense ratio for all funds was 1.14%, but funds with an expense ratio above that level held less than 10% of fund assets at the end of 2016. So it is very misleading when a fund company touts "below-average fees."
Trends in Active and Passive Funds
Morningstar research has proven that mutual fund costs are a reliable predictor of future fund returns, in that low-cost mutual funds generally outperform their more-expensive peers. During the past few years, assets have been migrating toward lower-cost funds, and this trend has accelerated. Passive funds continue to be significantly cheaper than active funds, costing investors an average 0.17% in 2016, 58 basis points less than active funds. More recently, passive funds' cost advantage has grown, as the asset-weighted costs of passive funds decline faster than those of active funds.
With such a large cost difference between active and passive funds, flows into passive funds have grown rapidly in the past decade, with annual flows doubling from about $200 billion in 2007 to more than $400 billion in 2016. Also, starting in 2011, flows into passive funds (which includes ETFs and index funds) have outpaced flows into active funds every calendar year, despite the fact that active funds outnumber passive funds by eight to one.