Partner Talk®
August 2015
Limiting Portfolio Expense
Robert Capanna
[email protected]
There are truisms in life that are also true in investing, and there are some that are not.
“What goes up must come down” works well for gravity and stock bubbles, but less well for
carefully considered investments.
“Nobody knows the future” – a truism at the core of Prudent Management Associates’
investment philosophy – is an obvious fact that frequently slips out of mind, to one’s
detriment when it does.
“You get what you pay for” is generally true in life, but frequently dead wrong in investing.
In fact, high prices can make otherwise good investments bad bets, and high expenses can
overwhelm an investment’s potential return. That’s why fund expense is one of PMA’s
primary screens when assessing which mutual fund managers to include in PMA portfolios.
Not only do low expenses matter in terms of what they contribute to investment return, but
they can also be a prime indicator of funds that are likely to perform well in the future.
A study conducted by researcher Russel Kinnell for Morningstar in August 2010 found that
expense was a far better predictor of future performance than was the famous Morningstar
star rating system, with low-cost funds out-performing high-cost funds consistently across
all time periods and asset classes studied.
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Kinnel noted, “If there’s anything in the whole world of mutual funds that you can take to the
bank, it’s that expense ratios … are strong predictors of performance.”
One piece of good news for investors is that fund expenses have been declining fairly
steadily since 2000. According to the 2015 Investment Company Fact Book, the average
expense ratio in equity mutual funds was 160 basis points (1.6%) in 2000 and 133 basis
points in 2014 – a decline of 17% (all averages used in this note are reported in the Fact
Book).
The Fact Book points out there are several contributors to this trend. One is that expense
ratios tend to decline as fund assets increase because a fair number of those expenses –
such as transfer agency fees, accounting and audit fees, and director’s fees – are fixed in
dollar terms and result in a lower ratio when spread against a broader base of assets.
Mutual fund assets have increased significantly during this period, with domestic equity
funds growing from $1.9 to $2.2 trillion, for instance – a 16% increase.
Another factor is the growth in the industry as a whole and the competitive pressures that
that has brought to bear. From 1990 to 2014, the number of households owning mutual
funds more than doubled – from 23.4 to 53.2 million. Instead of this increased demand
supporting higher prices, however, competition among existing funds, competition from
new funds entering the industry and competition from new investment products like
exchange traded funds have all combined to lower overall average fund expenses and
fees.
But investor behavior has also had a tremendous impact on the fees the average investor
actually pays. Asset-weighted average expense ratios – the actual fees paid for every
dollar invested – have trailed the overall fund expense average significantly. Looking again
at equity mutual funds, investors paid asset-weighted average expenses of 99 basis points
in 2000 (62% of the simple average expense of 160 basis points) and asset-weighted
average expenses of 70 basis points in 2014 (53% of the simple average expense of 133
basis points), for a decline in asset-weighted expenses of 29% in 15 years.
Investors have clearly intuited the advantage that low-cost funds provide, concentrating
their assets in lower-cost funds. The Fact Book reports that 74% of all equity mutual fund
assets are invested in funds with expense ratios in the lowest quartile of funds by expense.
This overall effect has also been influenced by the increased popularity of index funds,
which do tend to have lower expenses than actively managed funds because their
management effort is limited to replicating the performance of a given benchmark.
Surprisingly, though, there is a broad range of expense ratios within index funds: index
equity fund expenses range from 8 basis points at the tenth percentile of funds ranked by
expense to 156 basis points at the 90th percentile, so buying an index fund is not
necessarily an automatic bargain.
Like the overall picture, however, investors favor the index funds with the lowest expense,
with 85% of assets invested in index equity funds with expense ratios in the lowest quartile
of funds by expense. This holds true for actively managed equity funds as well, with 70% of
the assets in the lowest 25% of funds by expense.
Consequently, investors are experiencing asset-weighted expenses near the bottom of the
range of fund expenses in all asset classes:
 Actively managed equity funds have an asset-weighted average expense ratio of 86
basis points and a 10th percentile expense ratio of 72 basis points.
 Actively managed fixed income funds have an asset-weighted average expense
ratio of 63 basis points and a 10th percentile expense ratio of 48 basis points.
 Index equity funds have an asset-weighted average expense ratio of 11 basis points
and a 10th percentile expense ratio of 8 basis points, as noted above.
Not surprisingly, total portfolio expense – the sum of the asset-weighted expenses of all of
the funds in a portfolio – has declined as well. Morningstar reports that the average mutual
fund investor had an asset-weighted average portfolio expense ratio of 95 basis points in
2000 and 71 basis points in 2013, a 25% decrease.
So how does PMA compare? Since PMA is proactive about fund expense, we compare
very well indeed, with PMA asset-weighted expense ratios significantly below the industry
averages and at or below the tenth percentile of expense: 73 basis points for actively
managed equity funds (85% of average); 27 basis points for fixed income funds (43% of
average); and 8 basis points for index equity funds (73% of average). PMA’s overall assetweighted average portfolio expense ratio is 39 basis points (53% of average).
Fund expense is not the whole story, but it is an important part of why some investment
strategies succeed and others fail. It is also an important ingredient in the complex
business of assessing the likelihood that funds will do well in the future, and it is a very
good indicator of investment style – conservative managers generate lower expenses by
trading less and holding investments longer.
So fund expense is one of the few win-win propositions in the investment world –
controlling portfolio expense yields better returns and costs less too.
What’s not to like?