Die, Horse, Die!

Cheap Funds Are Chic
Yesterday's The Wall Street Journal carried an Opinion piece sounding a familiar theme: "You're Paying Too Much for Investment Help." Written by Burton Malkiel, the article lambastes the U.S. mutual fund industry for overcharging for active management and for not passing along its economy of scale to shareholders. In 1980, the asset-weighted annual expense ratio for funds was 0.66%. Today, Malkiel argues, the asset-weighted expense ratio is almost identical at 0.69%, even though the industry boasts more than 100x the assets of 1980.

It's a fair point. If I wished to take apart Malkiel's argument, I'd show how the industry's fee structure has changed since 1980. Front-end sales changes have largely disappeared, replaced in many cases by 12b-1 fees. As front-end loads do not appear in official expense ratios and 12b-1 fees do, this switch has the effect of making today's funds look more expensive. However, this switch is offset by the fact that there are proportionately more assets today in institutional funds, index funds, and bond funds. So, overall, it's a wash: Expenses for today's funds may reasonably be compared to those of yesteryear.

However, this particular war has already been waged--and won. As recently as the start of the New Millennium, new assets flowed fairly equally into low-cost, midpriced, and expensive funds. Indeed, for some time periods circa 2000, there were more monies moving into funds with expense ratios exceeding 1.5% than into those with expense ratios of less than 0.5%. Today, it's the reverse, with institutional shares and exchange-traded funds accounting for effectively all of incoming assets. (As you may know, institutional shares have gone retail, becoming the share class of choice for 401(k) plans and financial advisors.) Over the trailing 12 months, the 10 best-selling mutual funds have been five index funds, five institutional funds, and zero--count 'em, zero--actively managed retail share classes. 

There's nothing wrong with continuing to beat this particular horse. The importance of low-cost investing cannot be overemphasized. But ... the beast looks to be dead. Really, it does. 

Off the Balance Sheet
That said, despite the victory of low-cost funds, it's not clear that fund investors are paying less overall than they were 30 years ago. In selling ETFs and institutional shares, financial advisors have swapped out commissions and adopted instead asset-based fees, which don't appear in fund expense ratios. This leads to a different math--and not always a cheaper end result. For example, the new-style sale of an index fund that carries expenses of 0.2%, coupled with an advisor's fee of 1% annually, leads to a bundled cost of 1.2% annually. Over 20 years, that makes for a back-of-the-envelope payment of 24 percentage points. (We'll keep things simple by ignoring compounding effects.) In contrast, an old-style 8.5% front-end load fund that had an annual expense ratio of 0.60%,would have cost an investor 20.5 percentage points over 20 years. 

If Malkiel wishes to beat a living horse, financial advisors await. 

The Global Perspective
Also worth noting is that Malkiel's editorial is spot on the mark outside the United States. Elsewhere in the world, the cost battle has barely begun. As part of its biennial Global Fund Investor Experience report, which examines and scores the experiences of fund investors in various countries, Morningstar compiles the median asset-weighted expense ratio for funds across the globe. In most countries, these expense ratios are roughly double the U.S. level. What's more, they are not trending down. There is no equivalent of Burton Malkiel--or Jack Bogle--outside of the States.

Sometimes, It's What You Don't See
Survivorship bias--that is, failing to take into consideration funds that have merged or liquidated out of existence--is an important issue for measuring fund performance. Morningstar's David Harrell forwarded me a story about one man's understanding of survivorship issues when helping to formulate U.S. military tactics during WWII. It's not directly applicable to investing, but indirectly any example of clear thinking may prove helpful. It's a fun story, too. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.