Mutual Funds

Surprise: Fund Fees Hold Steady Amid Market Rally


(Adds Investment Company Institute data in the third paragraph.)

For investors, mutual fund fees are about the only things that haven't been turned upside down by the Great Recession and wild markets of the last couple years.

Data from Morningstar (MORN) put the expense ratio for the average U.S. stock or bond fund at 1.24% as of Apr. 8. That's the same ratio that prevailed at the end of both 2008 and 2009.

Using a different methodology, the mutual fund trade organization Investment Company Institute released estimates on Apr. 13 showing investing costs were unchanged in 2009. The average investor paid total fees and expenses of 0.99% on equity funds and 0.75% on bond funds last year, the institute said. Both were the same as 2008 estimates.

Expenses have held steady even as fund managers' revenue was slashed, then restored somewhat by the stock market's resurgence. The broad Standard & Poor's 500-stock index fell 57% from its Oct. 9, 2007 peak to Mar. 9, 2009, but has since rebounded 77%. The index on Apr. 12 was 24% off that 2007 high.

Investors have been yanking money from equity mutual funds at a rapid rate, further reducing the amount managers collect from expense ratios, which are charged annually on a percentage of assets under management. According to TrimTabs Investment Research, investors pulled $36.2 billion from U.S. equity funds in 2009, following withdrawal of $162.4 billion in 2008. Bond mutual funds saw $463.8 billion of inflows in 2008 and 2009.

Profit margins in the mutual fund industry have been squeezed, says Sean Collins, senior director of industry and financial analysis at the Investment Company Institute. "There is pretty strong competition in the business for investor dollars," Collins says. "That keeps people on their toes."

Fund fees compound year after year

Investing experts still believe that many people are overpaying for mutual funds management and other investment advice.

"Over the short term, [fees] might not seem significant," says Stephen Horan, head of private wealth management at the CFA Institute, the independent organization that awards the chartered financial analyst designation. However, he points out, a 1.5% annual fee can cut a portfolio by about one-third over 30 years. Because the fee compounds year after year, its bite is relatively constant, even if annual returns vary: A fund with a 5% annual return will lose 35% in fees over 30 years, while a fund that returns 10% loses 34% in fees, he says.

Although it's hard to confirm, investing experts believe that a disappointing stock market over the past decade has caused investors to scrutinize fees. "In a time when stock market returns are low, there appears to be more interest in expenses," says Standard & Poor's equity analyst Dylan Cathers, who helped develop S&P's mutual fund ranking methodology.

Brad Barber, a finance professor and expert on investor behavior at University of California, Davis, agrees. However, he says, the vast majority of investors choose funds based first on their past performance, and second on fees. Predicting future fund performance based on past returns is very difficult, as fund marketing materials point out. And research shows that the most expensive funds—those whose expenses rank in the top 20%—are actually the worst performers, Barber adds.

Generally, funds are divided into two starkly different categories: Passively managed funds buy and hold diverse assets based on indexes, such as the S&P 500. Actively managed funds buy and sell assets according to the judgment of fund managers. Salaries for research and management are often paid out of higher-than-average fees at active funds, while passive funds can charge much less.

can active management add value?

Several index funds that track the S&P 500 have expense ratios of 0.1% or less. Low-cost competition for investor dollars also comes from exchange-traded funds, or ETFs, which are usually managed passively. The average ETF has an expense ratio of 0.57%, according to Morningstar.

Despite the costs, actively managed funds can be necessary for those who wish to invest in parts of the market where expertise is valuable, says William Droms. a Georgetown University business professor. In real estate investment trusts, small-cap stocks, and international stocks, "there is an opportunity for active management to add value," he says.

Academics have argued for decades about whether active management actually can improve returns. What is clear is that, because of outflows and market declines, stock managers have less to spend.

"Revenues for the industry are definitely down," Horan says. Mutual fund companies have laid off workers, but there is no way to know exactly how funds are cutting expenses to make up the shortfall. Most fund budget cuts are not going to be noticeable to investors—at least not right away, Horan says.

For example, funds could pay less for research, potentially hurting investor returns, Barber says. Or they could cut out spending on marketing and advertising, which "clearly has no benefit for existing shareholders," he says.

Either choice is less than ideal for an industry in the midst of a multiyear slump. Unless there's a full-fledged turnaround in investor sentiment, fund companies will continue to feel the squeeze.

Steverman is a reporter for Bloomberg News in New York.

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