Two patterns concerning total expense ratios emerged from an annual analysis of mutual fund expenses at Lipper. These patterns are consistent across classifications/objectives and fund type.
The first shows that asset-weighted average total expense ratios tend to be lower than average total expense ratios. The latter is a ratio that is a simple average for a set of funds; the former essentially counts the bigger funds with more weight. (As one example, large-cap institutional funds have an average total expense ratio of 1.004%, compared to an asset-weighted average ratio of 0.744%.). The difference between these two ratios stems from economies of scale. As a fund grows in size, like a corporation, it may achieve operational efficiencies.
However, this cannot continue indefinitely. At a certain size, economies of scale decrease. At some point, large complexes may even experience "diseconomies," or the situation where larger actually means higher costs.
Weighting the expense ratio by the assets of the portfolio equalizes the discrepancy between small funds with higher expenses and larger funds, which can charge lower expenses.
The second finding of the analysis concerns load-types. Institutional funds tend to have lower total expense ratios as compared to front-end/no-load funds.
The highest expense ratios typically go to back-end/load funds. For example, institutional long municipal debt funds' average total expense ratio is 0.602%, compared to 0.765% for front-end load/no-load funds. And back-end load/level-load long municipal debt funds' average total expense ratio is higher still at 1.485%.
The expense differences between funds of different load-types can be partly attributed to 12b-1 and non-12b-1 service fees incurred based on the method and type of distribution of the fund. Additionally, institutional funds may only be available to specific investors and, therefore, incur fewer advertising costs than their retail counterparts.
Index funds and exchange-traded funds: These are less expensive than actively managed funds, of course. But what's not so apparent is that the impact of weighting total expense ratios by asset level generally produces more significantly variations in numbers for index funds because of their economies of scale.
For example, when considering actively managed front-end load/no-load sector equity funds, the asset-weighted average is 68% less than the average total expense ratio. For front-end load/no-load sector index funds, it's 30% less.
Index funds are often more heavily driven by non-management expenses since management fees are already at a minimum due to their passive investment style.
Funds of Funds: The asset-weighted average and average total expense ratios for funds of funds are difficult to compare to other types. The funds of funds total expense ratios contain expenses known as underlying fund expenses. Comparing the total expense ratios for funds of funds and non-funds of funds entails comparing expenses containing different components.
However, mixed-asset non-funds of funds do have similar average and asset-weighted average total expense ratios to lifestyle and lifecycle funds of funds. This is most likely because, despite the different expense components, they invest in a similar mix of equity and fixed-income investments.
Actively Managed Funds: Average and asset-weighted average total expense ratios for actively managed funds vary by Lipper classification/objective. Equity funds are divided into five groups: U.S. diversified equity, balanced/mixed equity, other domestic equity, sector equity, and all world equity. These groups are further split into smaller sub-groups. Across load-types, other domestic equity, sector equity, and all world equity groups have the highest average and asset-weighted average total expense ratios. Within equity, the groupings are not consistently more expensive than one another.
However, equity funds are more expensive than fixed-income funds. The asset-weighted average for front-end and no-load equity funds is 0.897%, while the asset-weighted average for front-end/no-load fixed-income funds is 0.487%.
Fixed-income funds are divided into three groups: taxable fixed-income, money market, and municipal debt. Across all three load-types, money market funds have the lowest average and asset-weighted average total expense ratios, ranging from 0.205% to 0.343%. The taxable fixed-income group has the highest average and asset-weighted average total expense ratios across the three groupings of funds.
Sasha Franger is a fiduciary research analyst at Lipper.
For more information on investments, visit www.bankinvestmentconsultant.com
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