Expense ratios on long-term mutual funds that invested in stocks dropped two basis points in 2012, according to the Investment Company Institute. Expense ratios dropped one basis point on bond funds.

But those ratios have a long way to go, before they go as low as exchange-traded funds, according to Morningstar research.

For mutual funds, investors paid an average of 77 bps (77 hundredths of one percent) on every $100 in assets to cover expenses in an equity fund, according to the ICI. For bond funds, the rate was 61%.

For exchange-traded funds, investors (or traders) paid 17 bps for expenses in a U.S. stock fund, according to Morningstar. Expenses for taxable and municipal bond ETFs were 26 bps.

The only type of mutual fund to match that 17 bps expense level was money market mutual funds, the ICI said.

Why? With interest rates at historically low levels since the credit crisis of 2008, 97% of money market funds now waive at least some of their expenses. That is "to ensure that fund net yields did not fall below zero," the ICI said, in its report on expense ratios.

The disparity in expense ratios is due to the passive nature of exchange-traded funds, to date, said Michael Rawson, ETF analyst at Morningstar, the fund research and rating firm. They eschew shooting for above-market returns, instead choosing to match their holdings to the components of an index, such as the Standard & Poor's 500.

"Index products are just cheaper to run. You don't have to pay a portfolio manager. You don't have to pay a team of analysts," he said.

Actually, you do have to pay for a portfolio manager, he said. But one portfolio manager can handle 20 to 30 funds, at a time. In ETFs, a manager "is running a program that is a computerized program that helps them rebalance the fund and it's very scalable," he said.

The expense ratios calculated in the ICI report cover not just portfolio management, but fund administration and compliance expenses as well as shareholder services, record-keeping, 12b-1 distribution and marketing fees and other operating costs.

Over the long-haul, average expenses on stock funds have come down from $1.07 for every $100 in assets in 1993 to 77 basis points in 2012, a drop of 30%, ICI noted.

Expenses in stock funds have dropped for the third year in a row, after increasing 3 points in 2009. That's because of large outflows, after the crisis that erupted in 2008, which leaves fewer assets to cover funds costs such as transfer agency fees, accounting and audit fees and directors' fees that are "more or less fixed in dollar terms, regardless of fund size," the trade organization said.

Also helping to drive down expenses is "a shift by investors toward no-load share classes, particularly institutional no-load share classes," ICI said.

ETFs don't face some of those categories of expenses at all, Rawson noted.

There are no distribution fees, because, on an ETF, "you're buying it on an exchange just like any other stock," Rawson said.

And an ETF company has much lower record-keeping expenses, because ... the relationship is between a firm such as Charles Schwab & Co. and its clients. "When you buy an ETF, they don't know who it is," that is holding its fund's shares, Rawson said.

Money funds, for their part, always have had the lowest expense ratios. But it took from 1993 to 2008 for their expenses to fall from 52 points per $100 in assets, to 35, a drop of 17 basis points in 15 years. From 2008 to 2012, because of the waiving of expenses and depressed interest rates, the ratio fell 18 points, in four years, to 17 points, in four years.

All told, money funds waived $4.8 billion in expenses in 2012, nearly four times the amount waived in 2006.

After 20 years, investors have now put $1.4 trillion into index-based ETFs. But they also have $1.3 trillion in index-based mutual funds.

But the new money in index funds has gone into ETFs, not mutual funds, Rawson said. The only really successful vendor of index-based mutual funds has been the Vanguard Group, which has long touted both the benefits of not trying to outperform the market and has been ferocious about keeping costs of its operations down.

The Vanguard 500 Index Fund Investor Shares (VFINX), which invests in 500 of the largest U.S. companies, for instance, has an expense ratio of 17 bps. Just like the ETF stock fund average counted by Morningstar.

But the ETF version of the same fund, the Vanguard S&P 500 ETF (VOO) has an expense ratio of 5 bps.

Overall, in fact, Rawson says, the only mutual funds whose expense ratios are coming down are those that are index-based.

Which means actively managed funds are going to have to take a hard look at their cost structure. And that means their portfolio managers and their compensation.

"Buyside people are just very handsomely paid," Rawson said. "These guys are making half a million or a million dollars, in a bad year."

Actively managed companies are "going to have to wake up at some point, and say 'Look, we're losing a ton of assets and a ton of opportunity to ETFs. We need to cut our expense ratios,'" he said.

 

 

 

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