Why Some Already High-Cost Funds Are Looking Even Pricier

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.

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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.

Therefore, if overall assets fall and operating costs remain the same, all else equal, a fund's expense ratio will increase to cover those costs. For example,

This fund got caught in the trap mentioned above. An estimated $4.65 billion poured out of the fund during the past five years, and total assets dropped to $952 million, mostly stemming from poor relative results since 2009. Nevertheless, the median expense ratio for its large-cap no-load peer group also fell from 0.97% in 2013 to 0.90%. The fund's expense ratio increased to 1.12% from 1.04% as it bled assets.

Conclusion Executives at firms such as Montag & Caldwell may see such expense-ratio increases as what's needed to cover their costs. But they should keep in mind that from an investor's perspective, it simply looks like a price increase, coming at a less than ideal time. Former hedge fund manager Andy Kessler pointed out the dangers of raising prices under such circumstances in a recent Wall Street Journal commentary, "The High Cost of Raising Prices." Applying that thinking here, raising prices will only make it likelier that--all other things equal--more money will be pulled from such funds.

There are no easy answers for actively managed funds wishing to remain competitive. Certainly, mediocre or poor performance is often a big reason for the exodus from active equity funds in particular. But more active firms need to take a much harder look at the fees they charge and become far more proactive in cutting them. While the behavior of financial markets isn't under their control, what they charge clients always is.