Fees and expenses incurred by investors who buy mutual funds have been declining since 1980, and that continued into 2004, according to a new report from the Investment Company Institute of Washington.

Last year, fees and expenses on equity funds decreased by four basis points. From 1980 to 2004, these fees and expenses have decreased by 113 basis points, from 2.32% to 1.19%, a 49% decline, the ICI said.

In 2004, the average fees on bond funds declined by two basis points to an average of 92 basis points. In 1980, they averaged 2.05%, and in the years since, they have declined 55%, according to the ICI. Last year, money market fund fees fell by one basis point to an average of 42 basis points. Since 1980, when they averaged 55 basis points, they have fallen 24%.

There are two kinds of fees that investors have to pay when purchasing and holding mutual fund shares: sales loads and mutual fund expenses. Sales loads are a one-time fee that investors pay, either at the time of purchase or when shares that are held less than a given number of years are bought back. The expense ratio, the percentage of total fund assets that is used for the operation of a mutual fund, is used to cover portfolio management, fund administration, shareholder services, distribution charges known as 12b-1 fees and other various costs.

In 2004, sales loads remained the same and, therefore, had no effect on equity fund fees and expenses, the ICI found. But average expense ratios declined for four main reasons.

First, many funds experienced appreciable asset growth and lowered fees as a result of realized economies of scale. Equity fund assets increased by $700 billion last year, due to capital gains from good fund performance and $178 billion just in new net cash flow.

This increase in equity mutual fund assets reduced expense ratios because some funds have breakpoints in their management contracts, which means that as their assets grow, their management fees decline in percentage terms. In addition, some fund expenses, such as audit and transfer agent fees, are fixed and become an appreciably lower cost for an investment advisor as a fund's assets rise.

Second, many funds cut fees for competitive or regulatory reasons. They either cut their fees outright, added new breakpoints or offered fee waivers, the ICI said.

Together, growth in fund assets and competitive fee cuts led to a 2-3/4-basis-point reduction in fund fees.

Third, the market share of funds with low expense ratios increased last year. The increase in the market share of low-expense-ratio funds accounted for about one basis point of the four-basis-point decrease in the average expense ratio of equity funds in 2004.

The popularity of low-expense funds continues to increase, the ICI said. "Equity fund assets typically have been concentrated in funds with below-average expense ratios. This pattern was accentuated in 2004, in part, because investors skewed their purchases of new fund shares toward those funds with the lowest expense ratios," according to the ICI report. Notably, in 2003, when 22% of net flows to equity funds went to funds with expense ratios of less than 50 basis points, in 2004, that increased to 27% of net flows to equity funds with expense ratios of less than 50 basis points.

Fourth, many funds with performance-based fees fell short of their benchmarks and thereby automatically lowered their fees. This resulted in one-quarter of a basis point reduction in fees.

As to other reasons why individual funds decided to decrease their expense ratios, a handful of advisors decided to offer fee cuts as a result of legal settlements having to do with late trading and illegal market timing. However, this accounted for only one-tenth of a basis point of last year's four-basis-point decline in equity fund fees.

Among bond funds, the average fees and expenses that shareholders incurred plummeted two basis points in 2004, to an average of 92 basis points.

As with equity funds, bond funds' expense ratios also decreased due to a marked shift in assets toward funds with lower expense ratios. Bond funds experienced an $11 billion net cash outflow in 2004. However, the 10% of bond funds with the lowest fees netted $10 billion in inflows. In addition, the average expense ratio of bond funds decreased slightly because of a rise in the proportion of bond fund assets held in no-load funds, while the average expense ratio of bond funds with sales loads declined by one basis point.

The average fees and expenses that shareholders incurred by investing in money market funds declined by one basis point to an average of 42 basis points. The ICI did not give a reason as to why this occurred.

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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