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Of the largest (in net assets) 250 U.S. equity funds as of June 30, 2006, 124 had annual net asset and expense ratio data going back to 1986. Thus, 124 U.S. equity funds were included in this analysis. These 124 funds held over $1.8 trillion in total assets, or roughly 40% of the $4.468 trillion held by 4,097 distinct U.S. equity funds (and exchange-traded funds) in the Morningstar Principia database as of June 30, 2006. (Distinct fund totals only count the primary share class of a multiple share class fund.) Although this is only a small percentage of all U.S. equity funds, the sample represented a large percentage of total U.S. equity assets.
The net assets of these 124 U.S. equity funds experienced dramatic increases over the 20-year period from 1986 to 2005. According to theory, then, expense ratios should have dropped, and they did--but not by much. It's difficult to say, however, by how much they "should have" declined. From a consumer's viewpoint, expense ratios should have fallen more. As, John Bogle recently remarked of the mutual fund industry: "We've imposed soaring costs on our investors that belie the enormous economies of scale in money management." ("The Relentless Rules of Humble Arithmetic," Financial Analysts Journal, Nov/Dec, 2005).
The chart "Die Hard Expense Ratios" below, shows both that rising net assets did not correlate--at least by much--with falling expense ratios. You can see how net assets and expense ratios have interacted from 1987 to 2005. The red line representing the mean net assets among the 124 prominent U.S. equity funds, rises steadily at first, as does the green line representing the median net assets of the group. Both lines refer to the Y-axis on the right side of the graph.
The other lines (pink, yellow and blue) represent mean, median and asset-weighted expense ratios for the 124 funds and refer to the left side of the Y-axis. The mean expense ratio for these funds declined by 8.6%, while the median actually increased by 3.5% (from .85% in 1985 to .88% in 2005). The asset-weighted expense ratio of the 124 funds declined almost 5.6% over the 20-year period, from .72% to .68%. Asset-weighting is a technique that makes the annual expense ratio of a fund proportional to its annual share of the total assets of all funds combined. Thus the expense ratios of larger funds are weighted more heavily since they hold more of the assets. It's analogous to equity indexes that are market-capitalization weighted.
GLACIAL SPEED
During the 20-year period, median net assets of this group of funds increased by roughly 1,600%--or by 1,650% using mean asset figures. As already noted, two of the three expense ratio metrics showed slight declines of 5.6% and 8.6%, whereas one expense ratio metric indicated an increase of 3.5%.
As a general rule, the asset-weighted expense ratio is probably the most useful gauge since it more accurately measures the "economies of scale" phenomenon. Therefore, this sample of funds experienced a modest decline of 5.6% in the asset-weighted expense ratio, while net assets rose 1,600%. If there are economies of scale, they are being implemented in mutual fund expense ratios at a glacial speed.
During the market declines of 2000 to 2002, net assets fell and expense ratios increased by all three measures: asset-weighted, median and mean. In the following period of recovery, 2003 to 2005, net assets increased and expense ratios declined. Clearly, asset levels appear to have affected expense ratios in recent years. Score one for theory. However, during the six years from 1990 to 1995, expense ratios were essentially constant, while net assets increased by 300% (using mean or median figures). Score one for greed.
Despite the confounding relationships between net assets and expense ratios during certain time periods, it does appear that at higher levels of net assets, expense ratios tend to be lower. There's a negative correlation between median net assets and asset-weighted expense ratios over this 20-year period (see "Gentle Slope," below). At higher asset levels, expense ratios tend to be smaller. However, we're only talking about a "bandwidth" of 12 basis points from the high expense ratio to the low (.79% to .67%). The R-squared of 0.60 indicates that during these 20 years, only 60% of the movement in the expense ratio of these 124 funds could be explained by the net assets of the funds. (If mean, rather than median, net assets are regressed against the asset-weighted expense ratio, the R-squared is 0.58).
GREED YEARS
Let's look at the relationship between annual percentage changes in median net assets and the annual percentage changes in asset-weighted expense ratios (see "Shotgun Pattern" below). The northwest quadrant (pumpkin color) and the southeast quadrant (light blue) represent correlations between assets and expense ratio that jibe with the theory. The NW quadrant represents declines in assets and corresponding increases in expense ratio, whereas the SE quadrant represents rising assets and declining expense ratios. The NW and SE quadrants square with the notion of economies of scale.
The NE quadrant (green for greed) represents grim reality. It encompasses the years where rising assets correlate with increases (or non-decreases) in expense ratios. The SW quadrant (yellow) is anti-theory because it represents falling assets and declining expense ratios. As if that's going to happen!
In 13 of the 19 years (not 20 years because 1986 is the base year in the "percentage change" calculation), the correlation between changes in assets and changes in expense ratio supports the notion of economies of scale (see "Annual Scorecard," below). Nine of the 13 were in the SE quadrant, where rising assets correlated with declines in asset-weighted expense ratios--albeit sometimes very modest, as in 1995 and 2003. The poster child year was 1997 (the southern most dot in the SE quadrant). That year, assets grew 35% and the asset-weighted expense ratio fell more than 8%.
The other four years of the 13 are represented by the four dots in the NW quadrant (1987, 2000, 2001 and 2002). Assets fell in each of those years--largely because of significant declines in the U.S. equity market--and each year, expense ratios rose. Apparently, misery loves company.
There were six green greed years: 1988, 1990, 1991, 1993, 1994 and 1999. In each of those years, represented by the dots in the NE quadrant, expense ratios increased in spite of rising net assets. In fact, during those six years, net assets rose by an average of 25% and expense ratios increased by an average of 2.5%. Economies of scale, where art thou?
Expense ratios are clearly affected by net asset levels. But they are also affected by decisions of the firm, and in some cases, those decisions are made independent of asset levels. One example is Vanguard Small Cap Index. In 1989, the expense ratio was 1.00% and its end-of-year assets were $33 million. At the end of 1990, its assets had grown 39%, to $46 million, but the expense ratio dropped 69%, to 0.31%. The decision to dramatically lower the expense ratio in 1990 was not made on the basis of economies of scale because assets hadn't grown that much. Rather, the decision was based on a choice to lower the expense ratio independent of the concept of economics of scale. Unlike Vanguard, most fund companies have been relatively slow to lower expense ratios despite substantial increases in net assets over the past 20 years. This study provides evidence that the expense ratios of mutual funds are responsive to net assets--just not always in ways that are consumer friendly.
Craig L. Israelsen, PhD, teaches family finance at Brigham Young University. You can email him at craig_israelsen@byu.edu.
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