Trends in Expense Ratios

There has been a tremendous increase in competition in the fund industry in recent years. The Investment Company Institute lists more than 7500 mutual funds out there today, double the number from 20 years ago. When you add in the increased efficiency afforded by the Internet, it should be no surprise that expense ratios have been dropping in recent years, providing a bit of good news for beleaguered investors.

The ICI recently issued a lengthy examination of trends in expense ratios, focusing on the last few years but extending back for the past couple of decades. Here’s what you need to know:

• Expense ratios for all types of funds dropped in 2011. The average investor in an equity mutual fund paid expenses of 0.79 percent last year, down 4 basis points from the previous year. The average investor in a bond fund paid 0.62 percent, down 2 basis points from the prior year.

• This is a continuation of a trend that has been going on for some time. Back in 1990, the average expense ratio paid for investors in stock mutual funds was 0.99 percent. So over the past two decades, these ratios have dropped by 20 basis points.

• The decline of expense ratios for bond funds has been even more dramatic. From 88 basis points in 1990, the average expense for a bond fund has dropped 26 basis points to its current level of 0.62 percent.

• Money market funds have seen, in some ways, the biggest decline of all. The average expense ratio for a money market fund was just 21 basis points in 2011. It was twice as much as recently as 2005, and was 50 basis points in 1999. Money market funds also have a history of waiving their expenses, either to keep their returns above zero or for competitive reasons. According to ICI, some 98 percent of money market funds are waiving expenses for at least some classes of investors.

• You might think that expenses for funds of funds – mutual funds that invest in a basket of other mutual funds – would be higher, since those funds have to pay not only their own expenses, but those of the other funds they invest in as well. But in 2011, the average expense ratio for a fund of funds was just slightly more than that of the average equity fund, at 0.83 percent. That’s down 4 basis points from the 2010 average.

Mutual funds use these expense ratios to cover such things as portfolio management, fund administration and compliance, shareholder services, recordkeeping, 12b-1 fees, and other operating costs. According to the ICI, expense ratios tend to vary inversely with fund assets. As a fund becomes more valuable, expense ratios generally decline, since much of the expense they’re covering – transfer agency fees, accounting and audit fees, directors’ fees – are fixed costs that don’t vary a lot with fund size. So when a fund is doing well, fixed costs become smaller relative to assets, but when the fund’s assets fall, the fixed costs eat up a higher percentage of the assets.

For instance, expense ratios tended to increase between October 2007 and March 2009, when the market was collapsing. But when the stock market had a strong year in 2010, expense ratios dropped that year by an average of 4 basis points.

Another factor is the continuing popularity of index funds. Index fund assets have grown from $170 billion in assets in 1997 to nearly $1.1 trillion in 2011, and index funds, for obvious reasons, are considerably cheaper to run than actively managed funds. In 2011, the average expense ratio for an actively managed equity fund was 0.93 percent, while the average equity index fund was at just 0.14 percent. The disparity for bond funds was almost as dramatic: Managed bond funds were at 0.66 percent, while index bond funds were 0.13 percent.

One thing that tends to increase expense ratios, on the other hand, is increasing overseas investment. International funds are generally more costly to manage than domestic ones, and assets have been rolling strongly into foreign funds this year: While U.S. stock funds have had net outflows of more than $28 billion this year through the end of April, international stock funds took in more than $9 billion.