Mutual Fund Expense Ratios See Biggest Spike Since 2000

The average fund investor paid more for his or her fund management in 2009 than in 2008. Overall, the average fund investor paid an expense ratio of 0.887% compared with 0.874% in 2008. It's the largest jump in fees since 2000. Those figures are for open-end mutual funds exclusive of exchange-traded-funds. You can see the details here.

The market's swoon was largely responsible. Official 2009 expense ratios largely cover a period from Nov. 1, 2008, through Oct. 31, 2009. The market hit bottom in early March 2009, and that reduced fund asset levels significantly. Most funds have breakpoints embedded that reduce management fees as assets rise and raise them as assets shrink. So, it's no surprise that expense ratios popped. In fact, when I wrote about 2008 expense ratios last year, I said that 2009 expense ratios were likely to increase.

The good news is that the market's tremendous rebound is already leading to lower expense ratios for fiscal 2010. We won't have the data until a year from now, but I would guess that 2010 expense ratios were close to in line with those of 2008. In fact, if you compare fund semiannual reports from last summer with annual reports printed in the last quarter, you can already see the trend to lower fees.

To arrive at figures for the average investor, we asset weight expense ratios. After all, the fees charged by the $162 billion  American Funds Growth Fund of America (AGTHX) matter to investors much more than $22 million W.P. Stewart & Co. Growth (WPSGX). We excluded institutional share classes, qualified access funds, and funds of funds.

Fees by Asset Class
Looking at fees by asset class, we see some dramatic shifts. Balanced funds saw a spike of 7 basis points to 0.88%, and alternative funds (such as long-short and commodities funds) also popped 7 basis points to 1.48%. International equity funds' expense ratios rose 6 basis points to 1.10%. Municipal bond funds' expense ratios rose 4 basis points to 0.76%. U.S. equity funds' expense ratios rose 2 basis points to 0.90%.

Only taxable bond funds saw a cut in expenses. There, the average investor's bill shrank 2 basis points to 0.72% thanks to much smaller losses in 2008 and strong inflows.

Flows Will Matter Again
Usually we attribute most of the changes in fees to inflows and outflows. However, when you have giant market moves, the impact of flows is just a drop in the ocean. Should the market settle down, flows will come back into focus.

At the moment, bond funds continue to be a big draw, and domestic equity funds had been in net redemptions. However, many U.S. equity funds now boast huge trailing 12-month returns, and that has already led to the first positive month of inflows in March. If this trend continues, it will be another tailwind for lower fees.

How Much Do Expense Ratios Matter?
So do these fee trends matter? You bet they do. Expense ratios have proved to be by far the greatest predictor of future performance. Investors tend to underestimate the effect because they remember the few exceptions in which high-cost funds performed well, whereas scores of high-cost funds are either liquidated or simply shrink from memory.

In fact, we've found that high-cost funds are far more likely to be liquidated than lower-cost funds. When you combine that with the fact that even surviving higher-cost funds the power of fees is dramatic. In Chapter 4 of Fund Spy, I detailed that bond funds in the cheapest quintile are 7 times more likely to survive and outperform than those in the highest-cost quintile. For U.S. stock funds, cheapest quintile funds are 2.5 times more likely to succeed than those in the costliest quintile.

Which Funds Have Had the Biggest Expense Ratio Cuts?
For investors what really matters is what happened at their funds rather than the fund world as a whole. So, let's take a look at some prominent cuts and increases.

 Fidelity Mid-Cap Stock (FMCSX) saw its expense ratio fall 22 basis points to 0.72% because of a performance fee that penalized the fund for lagging its benchmark in 2007 and 2008. However, the fund and market rallied in 2009, leading to greater assets and performance that will swing the performance fee to positive territory.

 Vanguard Growth Equity's  expense ratio fell from 0.72% to 0.51% as Vanguard negotiated lower-management fees when it replaced subadvisor Turner with Baillie Gifford and Jennison Associates. Of course, the low fees aren't much solace given the poor long-term performance shareholders have endured.

 Fidelity Small Cap Independence (FDSCX) had its expense ratio reduced from 0.94% to 0.75%. Like Mid-Cap, the fund got some performance demerits but has recently perked up a bit.

 Touchstone Sands Capital Select Growth (PTSGX) has benefited from a huge 70% gain in 2009 thanks to some winning picks in tech and health care. That helped the fund to lower expense ratios from 1.41% to 1.23%.

 Schwab Total Stock Market Index (SWTSX) enjoyed a big fee cut that had nothing to do with asset size or performance fees. Schwab decided to slice expenses at some index funds to 0.09% in order to undercut the competition and boost its 401(k) offering.

Who Boosted Expenses?
Looking at the funds with higher expense ratios, the main themes are shrinking assets and expired fee waivers. Fund companies will sometimes waive fees when a fund starts out in order to give a fair deal to those who jump in right away and to give funds an edge in performance. However, if assets don't pour in, the fund company has a hard call on whether to continue the subsidy or allow expenses to rise.

 Marsico Global (MGLBX), with just $119 million in assets, allowed expenses to nearly double from 0.75% to 1.40% as its waiver expired. It's not really a surprise, though, as even Marsico's biggest funds charge around that much.  Marsico Focus (MFOCX), for example, charges 1.31% on a $2.2 billion fund.

The same is true for  Appleseed (APPLX) fund, which saw expenses rise from 0.90% to 1.24% even though strong performance has boosted assets to $135 million. In fact, that 1.24% expense ratio is well below the 2.09% that the fund would be charging without any subsidies.

 Masters' Select Smaller Companies'  declining assets led expenses to rise to 1.62% from 1.39%. That's a pretty big spike and a shame for what was a pretty promising fund.

 CGM Focus  saw its expense ratio rise to 1.23% from 0.97% as performance rapidly turned on its heel from world-beating to doormat. A second factor is that the fund shorts stocks, and short interest has to be included in the expense-ratio calculation. Funds that can have varying levels of short positions, therefore, tend to have expense ratios that swing dramatically.

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