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Turnover, Asset Declines Put Upward Pressure on Fees


Equity fund fees are down, the industry insists. Not so fast, academics, Lipper and the General Accounting Office counter. As proof, they take a close look at how declines in assets and increases in turnover - pressures the business has succumbed to in this bear market - put upward pressure on fees.

The Investment Company Institute claims that largely because the industry has decreased compensation to sales professionals, equity fund fees have decreased 5% between 1998 and 2001 from 1.35% to 1.28%. Further, ICI Chairman Paul Haaga testified before the House Financial Services Committee last month that not only have fund fees declined, but investors are able to discern and select funds with lower fees 83% of the time.

A closer look at fund fees (see table) indicates not only that they are not so readily discerned or understood - but all fund fees are not created equal. Using data from Morningstar Principia Pro, this article aims to benchmark expense ratios for U.S. equity funds, international equity funds and domestic bond funds over a five-year period from 1998 through 2002.

Lipper, for its part, found that the expense ratio for stock funds increased 12% from 1.30% in 1998 to 1.46% in 2002. The GAO, using asset-weighted expense ratios in a report issued last month, found that the expense ratios for stock funds increased 8% from 65 basis points in 1998 to 70 basis points in 2001. When assets decline, as they have considerably for equity funds, down from $4 trillion at the end of 1999 to $2.5 trillion at the end of February, funds apply higher fee schedules, the GAO noted.

Turnover is another factor certainly worth looking at, particularly in a market as difficult as this.

Using our own analysis of Morningstar data, let's look first at U.S. equity funds. Of the nine equity style categories (growth, blend and value in small, mid and large sizes), only two had a decline in the 2001-2002 period compared to the 1998-1999 average, those being the small value and the small blend funds. Their expense ratios declined -2.1% and -1.9%, respectively, to an average of 1.18% and 1.27%.

Large value fund fees, on the other hand, increased by 5.4% to 1.07%, and large growth fees rose by 5.2%, also to 1.07%. Large-cap funds, as a group, experienced increases in expense ratios of 4% to 5% and declines in portfolio average net assets ranging from -16% to -24%. Mid-cap and small-cap funds generally had steady or slight declines in expense ratios, the exceptions being mid-cap value and small-cap growth funds.

A striking conclusion from the data is that there was no downward trend in expense ratios among domestic equity funds during the five-year period ending in 2002. To those who promote the idea that mutual fund expenses are declining, this data suggests a different picture. In fact, expense ratios are increasing in the fund categories that have the lion's share of investors' money - namely, among large-cap funds.

Steady Hands

Turnover, while it would cause fees to go up, does not appear to have become too great of an issue during this bear market. The average turnover ratio for large-cap value funds during the two-year period of 2001-2002 was only 11% higher than the average turnover ratio for the same funds during the two-year period from 1998 to 1999. And while small-cap value funds experienced nearly a 15% increase in their turnover rates, reflecting recent equity market volatility, these increases are nowhere as high as one might expect.

Most of the remaining fund categories' turnover was nominal. Large growth fund volatility was up a scant 1.3%, for instance.

The decline in net assets is another matter. A variable that can impact expense ratios tremendously is portfolio net assets. As net assets increase, the expense ratio supposedly declines (or at least doesn't increase) since the mutual fund company can spread its costs across a wider base.

This correlation was observable for several of the categories. For instance, each of the large-cap categories had declines in average portfolio size, and in each case, the expense ratios increased. Similarly, small value and small blend funds generally grew in assets and had declines in expense ratios, while their small-cap growth cousins lost assets and expense ratios increased slightly.

Among mid-caps, the correlation broke down, however. Mid-cap value funds had the largest increase (84%) in average portfolio size, yet had the largest increase in average expense ratio (7%).

Small International Increases

On the international front, we only looked at large-cap funds, since there were not enough mid-cap and small-cap international funds to conduct a meaningful analysis.

While each of the three large-cap categories of growth, value and blend experienced increases in turnover ratio, expense ratios increased slightly, 1.5%, only among blend funds. Expenses on large value funds fell -5.1%, and on large growth funds they declined -2.3%.