Will expense ratios creep back up?

By Morningstar

Uh-oh. After years of expense ratios falling, the trend has skidded to a halt, and we might even see them rise a bit in the coming years. That's bad news because we've found that costs are the best predictors of mutual funds' future returns.

From 2003 through 2006, the average fund investor's expense-ratio bill fell from 1% to 0.9%. That's a huge savings and was a long-overdue sharing of the economies of scale that advisers and the fund industry had been keeping to themselves.

However, in 2007, the average expense ratio stayed at 0.9%, and costs in some broad asset classes actually rose. We saw expense ratios on the rise in balanced and municipal-bond funds. The ratios for domestic-equity and taxable-bond funds dipped by 1 basis point. (A basis point is a hundredth of a percentage point.)

• Video: Anheuser-Busch a value trap?

Only international-equity funds, which have enjoyed a surge of popularity in recent years, saw a meaningful drop of 4 basis points. (Exchange-traded funds were not included in the study.)

To figure what the typical investor is paying, I exclude institutional funds and then asset-weight the remaining expense ratios. I use asset weighting to see what the typical investor is paying because we're much more likely to own American Funds Growth Fund of America (AGTHX) or Dodge & Cox Stock (DODGX) than we are to own Wilmington Aggressive Asset Allocation (WAAAX).

Investors seeking lower costs

The biggest reason asset-weighted expense ratios declined from 2003 to 2006 wasn't that fund companies cut fees, but rather that investors and their advisers were seeking low-cost funds, thus lowering the overall weighting of expense ratios.

Although investors and advisers act for a range of reasons, there are some fairly clear reasons they bought lower-cost funds:

• Some actively sought low-cost funds in the wake of poor returns during the 2000–02 bear market, which showed how damaging high costs can be when returns are small or negative.

• Many of the lowest-cost fund shops, such as Dodge & Cox, Vanguard and American, produced superior performance in the bear market (and over the longer term). Plus, they steered clear of the 2003 fund scandal, in which hedge funds and other investors were given preferential treatment from a number of mutual funds. Thus many investors were simply responding to the good results they got from low-cost shops rather than directly choosing low costs.

• The fund scandal spurred fund companies to lower costs after years of trying to boost fees. That was partly due to then-New York Attorney General Eliot Spitzer, who forced fee cuts on fund companies as settlement terms. We also saw fund companies and boards that rediscovered their fiduciary duties and looked for places to cut fees without being forced to by Spitzer, and some noticed that their competitors had cut fees and followed suit.

Advisers seeking higher costs

Advisers and investors are not monolithic. Some don't care about costs, and, to a degree, some prefer higher costs if the fund earns extra-large returns. The biggest spike in fees came in our balanced group, and it was driven by the explosive growth of Franklin Templeton Founding Funds Allocation (FFALX).

The fund has netted nearly $15 billion in less than five years because it charges a higher 12b-1 fee than the underlying funds it invests in. (A 12b-1 fee is an extra fee charged by some funds for promotion, distributions, marketing expenses and, often, commissions.) That makes it more attractive to advisers who keep the 12b-1 fee. Thus investors pay more to have three funds wrapped up together than they would if their advisers bought all three separately.

Continued: Bargains abound

 1 | 2 | next >