The Low-Cost Fund Arms Race

The Race to the Bottom 
Twenty years ago, new mutual funds generally cost more than older funds. The industry, of course, charged what the market would bear. And the 90s' market would bear much. At the time, most investors viewed landing the right star manager as being more important than haggling over a fraction of a percent of expenses. As a result, fund companies nudged up management fees on their launches. Also, many new funds carried 12b-1 fees to pay for their distribution costs, which further boosted expense ratios.

Those days are long gone. Just how long gone was demonstrated by the recent news of BlackRock slashing fees on several of its existing exchange-traded funds. It cut costs on  iShares Russell 3000 Growth (IWZ) and  iShares Russell 3000 Value (IWW) by more than 60%, dropping those ETFs' annual expense ratios to 0.09% from 0.25%. The company took  iShares High Dividend (HDV) even further, implementing a 70% markdown. At the same time, BlackRock launched several additional funds, each at the new, lower price point.

BlackRock had no choice but to go down. Vanguard has blitzed the ETF marketplace just as it previously blitzed the mutual fund market. Once regarded as late to the ETF game, Vanguard has attracted more new U.S. ETF assets over the past year than have its two chief rivals (BlackRock and State Street) combined. The only viable response from its competitors has been to follow the trend.

Morningstar's Market Observer group has created a picture that illustrates why fund costs will continue to decline.

  - source: Morningstar Analysts

Here we see the 25 largest mutual fund families. (It does not include ETFs, but if it did, the pattern would only strengthen.) The x-axis is performance as measured by Morningstar's risk-adjusted star rating. The y-axis is cost as measured by annual expense. Finally, the size of each dot is in proportion to the size of the firm. Vanguard, as the largest dot, is the largest mutual fund family, accounting for $2.1 trillion in stock- and bond-fund assets, as opposed to $1.2 trillion each for American Funds and Fidelity.

Performance is closely linked with expenses. From the bottom left, representing weaker risk-adjusted returns and higher costs, the dots move consistently up and to the right, toward higher returns and lower costs. Only American Funds, DFA, T. Rowe Price, PIMCO, and Harbor deviate significantly from a line drawn from John Hancock through Dodge & Cox at the upper right.

(Four of those five outliers can easily be explained. American Funds has several large funds with 3-star ratings that are on the border of receiving 4 stars; if and when they cross that mark, American Funds' dot will move sharply to the right. DFA's funds may have middling star ratings due to their volatility, but most have enjoyed high returns. PIMCO's position is mostly determined by a single fund, the giant  PIMCO Total Return (PTTRX); similarly, Harbor's results are due to two funds.)

This relationship between performance and expenses likely strikes you as obvious. These days, people take for granted that one more dollar for the fund company is one less dollar for the fund shareholder. In the 1990s, that notion was disputed. Many firms argued that high management fees were needed to finance top-quality research. An even stronger version of the claim that investors "get what they pay for" was made in the mid-2000s for hedge funds. It was widely believed, even by veteran investors. Only in the past five years has the low-cost argument fully triumphed.

Note that the dots become larger as the imaginary line moves toward the upper right. This might seem trivial as well--of course the fund companies with better-performing funds attract more assets and become larger. But once again, that would be a recent view. Twenty years ago, few fund-industry executives would have foreseen this development. They believed that funds were sold, not bought, and that assets accrued to those firms that built powerful, expensive distribution systems. Vanguard's refusal to pay brokerage platforms so as to be on no-transaction-fee programs was viewed as a major impediment to its asset growth.

(You may have noticed another pattern in the chart. Although only 32.5% of mutual funds receive 4- or 5-star Morningstar ratings, every company save John Hancock shows a higher percentage than that--and even Hancock is right at the mark. This outcome occurs because the graph depicts not the percentage of a company's funds that rate 4 or 5 stars, but rather, the percentage of assets that have those ratings. As larger funds become so through strong performance, industry assets naturally tend to cluster in higher-rated funds.)

The debate is over: Low cost won. The battles, however, are not over. Begun, the Discount War has.

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.