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Are Mutual Fund Expenses Really Falling?

The Investment Company Institute (ICI) -- the mutual fund industry's trade group -- just published a new research paper examining mutual fund expenses. Their conclusion? "Mutual fund fees and expenses fell to their lowest levels in more than a quarter century in 2008." It sounds wonderful, of course. But it's not true.
Because the ICI represents mutual fund managers, it's in their and their members' interest to make it seem like all is well in mutual fund-land. Which is why you often hear them talking about their "steadfast commitment to shareholders," how they're only concerned with acting "in the best interests of fund shareholders," and producing research papers like the current one.

In the report, the ICI tells us that equity fund "fees and expenses" have fallen from 2.32 percent in 1980 to 0.99 percent in 2008. But if you dig into the numbers a little bit, you can see a bit of sleight of hand at work.

First, the ICI has a unique way of calculating mutual fund expenses: they add expense ratios and sales charges together. Including sales loads inflates total expenses in the early years, because sales loads have fallen from the near-eight percent range in the 1980s to some five percent today.

Of course, sales loads are typically paid up front at the time of the investment. To estimate the annual cost of the load, it's necessary to spread that one-time fee over the investor's holding period, a calculation that hinges on just how long the typical investor owns their fund before cashing out.

To see how the ICI is estimating this annualized sales charge, you have to dig into their footnotes. There, you'll see that they're relying on a study of mutual fund redemptions that was done in 1990, using data that start in 1974. Why would they rely on 35-year-old data for this estimate? Because investor holding periods were much longer then, of course. In 1974, equity fund redemption rates were around 10 percent, meaning that the average investor held their fund for ten years. Today, that redemption rate is nearly 30 percent. If you can spread the cost of a sales load over ten years instead of three, it makes the annual cost much lower.

Secondly, the ICI uses asset-weighted averages (which overweights large funds, and underweights smaller funds), which allows their expense figures to benefit from the rise of institutional funds, index funds, and exchange-traded funds (ETFs), all of which have grown enormously during the period.

In 1980, index funds (or, more correctly, index fund, since Vanguard's 500 Index was the only one in existence at the time) had a market share of less than 0.5 percent. Today, their market share is over 11 percent. If you include ETFs (which, like index funds, typically have well-below average expense ratios), their market share is 19 percent.

Likewise, institutional funds -- which have low expense ratios but typically require a minimum investment of $100,000 or more -- didn't become a factor in the industry until well into the 1980s, as 401(k)s and IRAs became popular.

To demonstrate just how large an impact institutional funds, index funds and ETFs can have on asset-weighted expense ratios, I calculated the expense ratios for all equity funds both with and without these three types of funds. If you include all three, the asset-weighted expense ratio for equity funds was 0.78 percent last year. Excluding those funds, it rose to 0.94 percent -- an increase of 21 percent.

Finally is the biggest misdirection of all is the ICI's focus on expense ratios. As I said at the outset, the ICI writes that "[m]utual fund fees and expenses fell to their lowest levels in more than a quarter century in 2008." That is wrong, pure and simple. Expense ratios have fallen; expenses in dollar terms -- which, at the end of the day, are what really matter -- are near their peak levels.

It's no mystery why the mutual fund industry prefers to talk about ratios instead of dollars. When stated as a percentage, expenses are small numbers, typically under two percent. But when stated as dollars, they're staggeringly large.

In Figure Three of their report, the ICI shows that stock fund expense ratios have fallen from 0.99 percent in 2003 to 0.84 percent in 2008. So it's fair to say that expenses have declined in that period, right?

Not quite. Applying those ratios to the total dollars invested in equity funds paints a different picture. If we apply the ICI's 0.99 percent expense ratio in 2003 to the $2.9 trillion in equity fund assets for the year, equity fund expenses totaled $29 billion. Doing the same for 2008, we find that they totaled $47 billion -- a 62 percent increase in total fees in just five years. Not much of a decline, is it?

Of course, it's hard to make anything sound like a bargain when you tell someone they're paying $47 billion for it, and it's impossible to tell someone $47 billion is less than $29 billion. Which is why you'll never hear anyone in the industry refer to expenses as anything other than a ratio.

But don't be fooled. Those expense ratios represent real dollars, dollars that come directly out of your pocket. And the next time you read something from the ICI telling you that your mutual fund expenses are falling, remember that you're paying your expenses year in and year out in dollars, not percentage points.

Image via Flickr user EvenWu CC 2.0

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