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Fund Spy

Fund Fees Are Dropping

In Part One of a three-part series, Morningstar's Russ Kinnel details how last year's market rally led to a decline in expense ratios, allowing for cheaper funds.

Fund fees dropped in 2013 courtesy of the huge stock market rally that year. Market rallies cause the total assets under management of the fund industry to grow tremendously and that in turn triggers breakpoints in mutual fund management fees. Those breakpoints are built into a fund's fee structure so a fund charges less for each additional dollar managed over various AUM thresholds.

The industry also shares some other efficiencies from the greater economies of scale, though they of course keep quite a bit to themselves.

The average investor in open-end mutual funds paid 0.71% in expenses in 2013 versus 0.72% in 2012 and 0.78% in 2010. The figure has gradually come down from a peak of 0.95% in 2000.

We calculate a figure for the average investor by asset-weighting expense ratios so that big funds count more than small ones. We include all open-end funds except for funds of funds.

If we look at the average mutual fund instead of the average investor, the trend is the same but at higher cost. Today the average fund charges 1.25%, down from 1.28% in 2012 and off from a peak of 1.47% in 2003.

You can see the long-term trends in this graph.

If we break the data down by fund group, we see that most of the decline was in equities. The typical investor in U.S. stock funds paid 0.67% in 2013, down from 0.70% in 2012. The average investor in foreign equities paid 0.78% versus 0.80%. The typical sector fund investor paid 0.90% versus 0.92%.

In 2013, balanced funds dropped 2 basis points to 0.78% for the average investor. I was a little surprised to see bond-fund expenses drop, as most bond categories were flat for the year. Even so, the typical investor in a bond fund paid 1 basis point less, down to 0.60% in 2013. Municipal bonds remained flat at 0.59% for the average investor.

The good news is that expenses will likely come down more for fiscal 2014 barring a huge market swoon in the second half. The reason is that 2013's rally continued toward the end of the year so that the growth in assets wasn't fully captured by 2013's figures, which reflect the 12 months ended October 2013.

What's Driving Lower Fees?
Asset growth is by far the biggest driver, as funds typically have breakpoints set to automatically lower fees as assets grow. And the largest part of asset growth will usually be market performance, as in 2013.

However, a second component is fund flows. Fund investors have become smarter about buying cheaper funds. Last year, 95% of net inflows went into funds with expense ratios that ranked in the cheapest quintile of their category peers. The two years prior it was actually greater than 100% because you had money going out of pricier funds even as it was rushing into cheaper funds.

In the 1990s, investors were less choosy about fees. On average only 56% of net inflows went into the cheapest quintile in the '90s. Low costs generally lead to superior returns, so no doubt some of the money going into low-cost funds also reflects investors following performance as well as expenses.

A big component of that move to lower costs is passive investments. But it doesn’t stop there. Money has flowed into lower-cost institutional bond funds that are actively managed, too. And even within actively managed equity funds, quite a bit of the money flowing in ends up in lower-cost funds.

The table below illustrates just how much more investors have focused new money on low-cost funds.

Finding Low-Cost Funds
You can see how a fund's expense ratio stacks up on the fees tab.

In our free fund screener, you can search for funds with fees below their category average.  In our  Premium screener, you can search for can choose a maximum expense ratio and screen for only funds that are cheaper than that. 

Why You Should Care
Next week, I'll explore in depth why costs are important.


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