Fund Expense Ratios Continue to Fall

The following is an excerpt from the April 2006 issue of Morningstar FundInvestor. Each month we deliver cutting-edge research that you can turn into great investment ideas. Clickherefor details on subscriptions.

Good news. The typical investor paid less in percentage terms for fund management in 2005 than in 2004. That's two years in a row that expense ratios have come down.

In most asset classes, the asset-weighted expense ratio came down 4 or 5 basis points. For example, the typical retail investor paid 0.93% in expenses for a U.S.-stock fund in 2005 compared with 0.99% in 2004, excluding institutional share classes. Expenses for the typical investor in an international-stock fund fell from 1.17% to 1.10%.

By asset-weighting the figures (giving greater weight to big funds than small when calculating expense trends) we can figure out what the average investor paid. The trend toward slightly lower expenses was also at work in taxable bond funds. The typical investor paid 0.85% for a taxable bond fund in 2005 compared with 0.90% in 2004. However, municipal-bond fund expenses were steady at 0.74%, despite an increase in assets. As you may recall from our study last year, we found that investors were gravitating to funds with below-average costs in every broad asset class except munis. This may explain why the asset-weighted expenses for muni funds did not fall.

In dollar terms, fund companies still collected more in fees last year. That's because most funds saw an overall increase in assets under management last year, so fund companies were charging fees on a larger base. That helps explain why, despite cutting expenses on many funds, the industry still produced record-setting revenues in 2005.

Nonetheless, the results of our study are encouraging when placed in the context of the long-term trend. In last year's study, we pointed out that although expenses fell in 2004, they were still at about the same level they were 15 years ago--despite a remarkable increase in assets over that time. However, another year's worth of expense cuts helped the industry to finally make some progress.

In 1990, retail investors were paying an average of 0.95% in expenses overall for their funds. That figure had actually ticked up to 0.97% by 2004. However, last year the average came down to 0.91%. That slight drop is a paltry reward for all the increased economies of scale enjoyed by the fund industry over the past 15 years, but at least it's something.

A Few New Bargains
A few expense cuts make funds much more attractive. For example, Fidelity slashed fees on some of its index funds to just 10 basis points. That makes  Fidelity Spartan International Index  a real bargain as there aren't any funds nearly as cheap. I also like  Clipper Fund (CFIMX), which cut its expense ratio from 1.12% to between 0.65% and 0.75% (a new figure fully reflecting the cut hasn't been printed) when Chris Davis and Ken Feinberg were hired to take over.

Other funds saw their expense ratios drop even though they didn't alter their underlying fee structure. Most often that was because rising assets enabled the fund to hit breakpoints, which lowered fees. For example, asset growth led  Artisan International Value (ARTKX) to reduce its expense ratio to 1.31% from 1.56%. A recent slump caused  Fidelity Dividend Growth's (FDGFX) performance fee to go sharply negative resulting in an expense ratio of just 0.64%. The poor returns were largely due to Charles Mangum's bias toward blue chips and health care, so we still have faith that the fund will rebound.

Will the Fee Cuts Continue?
A portion of the fee cuts was the result of market-timing settlements with New York Attorney General Eliot Spitzer. However, those cuts are largely behind us, so it will be interesting to see if fund companies and boards will continue the momentum of the past two years in driving better deals for investors or if the cuts will run out of gas.