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Active U.S. Equity Funds Are Slowly Getting the Message on Fees

More actively managed U.S. equity funds cut their fees in 2017 than in 2016.

Fund companies finally seem to be getting more proactive about cutting fees. In response to investors moving money to index funds and low-cost actively managed funds, more U.S. equity funds cut their expense ratios in 2017 than in 2016.

We looked at the expense ratios for actively managed funds that invest predominantly in domestic stocks. There are nearly 1,750 such distinct funds. We sampled the expense ratio from each fund's oldest share class and eliminated any funds that did not have expense ratios in 2015, 2016, and 2017.

The difference from 2016 to 2017 was dramatic. In 2016, only 469 funds, or 26.8% of the total, cut their expense ratios. In fact, far more funds (596 or 34.1%) increased their expense ratios in 2016, with the remainder remaining unchanged. (To be fair, some of those increases likely owed to performance-fee adjustments. See the discussion below.)

The tide turned in a big way in 2017. Even though more than 300 funds haven't yet reported their 2017 expense ratios, 655--nearly half the total of reporting funds--cut their expense ratios in 2017. Meanwhile, only 258 funds reported expense ratio increases, a 57% drop in funds that raised their fees year over year.

Is This the Best You Can Do? While this change in direction is encouraging, the degree of change was underwhelming. The average cut in 2017 was just 6 basis points (or 0.06%), and the median was only a 3-basis-point (0.03%) reduction. It's worth remembering the point my colleague Patricia Oey made in the May 2017 Morningstar fee study: While the average fee that investors are paying for active equity funds is falling, it owes more to investors targeting low-cost funds rather than to funds cutting their expense ratios.

Indeed, as I pointed out last year, and as the 2016 and 2017 data bear out, some funds continued to raise their expense ratios even as money walked out the door and assets fell. In most cases, these funds are simply keeping their costs constant as assets fall, which leads to a rising expense ratio, all else equal. My guess is that executives at these funds don't think of this as raising prices, but the effect is the same.

So, why were the price cuts in 2017 so modest? Well, despite all the talk about clients coming first, asset management isn't that different from any other profit-maximizing industry. Most management teams charge what they think fundholders will bear. More specifically, most look at what their peers charge and try to at least stay in the ballpark.

This is the function of annual 15(c) reports, which show fund boards how much a given fund charges relative to its peers. So, rather than setting fees based on an absolute standard such as economies of scale or a desire to maximize returns, fees tend to be based on what other funds charge. This means that fees can fall collectively, but cuts tend to be modest and incremental.

Still, it's notable that many funds reduced their fees last year despite net outflows and/or falling assets. (It's possible that the Department of Labor's fiduciary rule forced some fund executives' hands as well.) Overall, actively managed U.S. equity funds saw outflows of nearly $200 billion in 2017, according to Morningstar Direct. (For the three years through January 2018, the figure is about $570 billion.)

Nevertheless, as many have noted, a strong bull market has bailed out active U.S. equity funds. Despite all the outflows, actively managed U.S. equity assets hit a 10-year high of nearly $4.5 trillion in January 2018. Rising assets then make it easier for fund companies to cut expense ratios.

But not all funds that cut their fees saw increased assets. Embattled

Some funds saw their fees fall because of performance adjustments. That's especially true in Fidelity's case, which cuts the fees on many of its actively managed funds when their rolling three-year returns lag their benchmarks. That was the case with

While adjusting fees based on performance is laudable, investors should keep in mind that such adjustments will reverse if relative returns improve. Indeed,

It will be interesting--but not pleasant!--to see what happens to fees during the next bear market as overall assets drop. For now, it's good to see active U.S. equity funds becoming more proactive in cutting their expense ratios. Nevertheless, unless competitive or market pressure increases, cuts are likely to remain modest and incremental.

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