Understanding mutual fund expense ratios can be confusing for the average investor. A general rule, often quoted by advisors and fund literature, is that investors should try not to pay any more than 1.5% for an equity fund. There are a variety of factors that contribute to a fund's total expense ratio. It seems as though non-investment factors, such as a fund's 12b-1 fee are discussed and written about at great length, while investment factors like a fund's investment strategy are rarely considered. (See also: Mutual Funds.)
Before we delve into some of the investment reasons for variation in expense ratios, it might be helpful to understand a fee's composition and how an investor pays for those fees. The total expense ratio is comprised of the investment management fee, a 12b-1 fee (also known as the cost of distribution) and other operating expenses. A shareholder pays the fee on a daily basis through an automatic reduction in the price of a fund. It can be difficult for the average investor to get a feel for how much is being paid for any particular fund.
Expense Ratios and Equity Funds
Mutual-fund expense ratios vary greatly from one investment category to another. As you might expect, funds with higher internal costs (trading costs, administrative costs, etc.) typically also have higher expense ratios.
International funds can be very expensive to operate and tend to have some of the highest expense ratios. International funds invest in many countries and, as a result, often require staff all over the world. Accordingly, international funds tend to have substantially higher payroll and research expenses compared to single-country funds that invest in only one country.
In addition, international funds often hedge investment exposure by purchasing foreign currency. This strategy and added cost are normally implemented to offset adverse changes in currency. According to Morningstar, a well-regarded mutual-fund research and rating organization, the average international equity fund with assets greater than $5 million has a 1.68% gross expense ratio. (See also: Broadening the Borders of Your Portfolio and Why Country Funds Are So Risky.)
Small-cap funds also tend to have expense ratios higher than the sought after 1.5% upper limit. Based on Morningstar research, the average expense ratio for a small-cap fund with assets greater than $5 million is 1.61%. Funds investing in smaller companies typically incur higher costs for research and trading when compared to the costs associated with funds investing in larger companies. Small-cap stock research can be expensive, partly because it is not nearly as accessible as large-cap stock research. As a result, it is very difficult for a small-cap fund manager to rely on secondary research as a basis for investment decisions. Accordingly, funds investing in smaller companies very often conduct primary research, which typically requires having several investment analysts contributing to the process.
At the same time, small-cap funds usually have higher trading costs than large-cap funds. Small-cap stocks are not as widely traded as large-cap stocks and, as a result, normally have higher trading spreads. Normally, the smaller the company, the higher the price you will have to pay to place a trade. In addition, small-cap funds tend to have higher turnover ratios than large-cap funds, which also impact trading costs. If a small-cap fund manager does not sell its winners, it can very easily become a mid-cap fund. Again, according to Morningstar, the average small-cap fund has a turnover ratio of 93%, while the average large-cap fund has a turnover ratio of 76%. (See also: Market Capitalization Defined and Determining What Market Cap Suits Your Style.)
Large-cap funds normally have lower expense ratios than both international funds and small-cap funds because the large-cap strategy does not necessarily require extensive teams of in-house analysts to support the investment process. Fund managers in this area can easily rely on outside research—and there is plenty of high-quality research to choose from. In addition, large-cap funds also tend to have lower trading costs compared to small-cap funds. Large-cap stocks are widely traded and normally have much smaller trading spreads. According to Morningstar, the average large-cap fund with assets greater than $5 million has an expense ratio of 1.45%.
Fundamental Analysis Vs. Quantitative Analysis
Another important consideration when evaluating an equity fund's expense ratio is whether management uses fundamental or quantitative analysis. Funds using a quantitative strategy often rely on models to construct portfolios. Here, models are doing most of the work and not the analysts. (See also: Introduction to Fundamental Analysis.)
Quantitative funds (or quant funds) normally have much smaller investment teams than fundamentally managed funds. On the other hand, quantitative funds tend to have higher turnover than fundamentally managed funds and often have higher trading costs. Trading costs, however, are not nearly as significant as the cost of human capital. In general, funds employing a quantitative strategy should charge less than funds using a fundamental approach.
In today's environment of full disclosure, most fund-family complexes are very candid about their investment processes. It is not uncommon for a fundamentally managed fund to provide a detailed overview of its investment approach on its website. Quantitatively managed funds, on the other hand, rarely divulge the specific details of their models. Shareholders of a quant fund are required to pay fees despite not knowing how the product is managed.
Active Management Vs. Passive Management
For investors who believe that fundamental analysis adds little value and that managers cannot outperform benchmarks, there are plenty of index funds available. Index funds normally charge far less than actively managed funds. In addition, index funds are highly tax efficient, which reduces a shareholder's overall costs.
Index funds can save you money in fees, but this strategy sometimes comes with other costs. For example, index funds do not have the ability to raise cash or alter allocations to address changing market conditions. If securities markets experience a downturn, your portfolio will decline by a similar amount. (See also: You Can't Judge an Index Fund By Its Cover and The Lowdown on Index Funds.)
Expense Ratios and Bond Funds
As far as fixed-income funds are concerned, expense ratios also vary significantly across investment categories. Overall, fixed-income fund expenses are lower than those of equity funds, but the amount depends partly on the specific investment category. Similar to equity strategies, bond strategies can vary significantly in terms of personnel, research, trading costs and foreign exchange necessary to effectively implement an investment process.
High-yield bond funds have some of the highest expense ratios among bond groups. The average high-yield fund normally has a team of highly trained and credentialed managers and analysts whose main responsibilities are to conduct fundamental research on corporate securities. Further, fixed-income analysts and managers who conduct fundamental research are normally compensated at a level almost comparable to those engaged in equity research. In addition, since high-yield securities have fairly low volume and larger trading spreads, individual trades are more expensive. According to Morningstar, the average high-yield fund with assets greater than $5 million sports a gross expense ratio of 1.35%. (See also: Handling High-Yield Savings Accounts.)
International bond funds also have high expense ratios, especially when compared to the more interest rate-sensitive domestic bond funds. Funds investing primarily in foreign bonds also have additional research costs. Investing globally requires knowledge about the many economies, geopolitical structures and markets around the world. At the same time, foreign bond funds, like foreign equity funds, often hedge currency exposure. According to Morningstar, funds focusing on foreign bonds have an average gross expense ratio of 1.35%.
In contrast, domestic bond funds investing primarily in high-quality government and corporate securities usually have the lowest expense ratios among fixed-income categories. Funds investing mostly in high-quality issues have lower trading costs and generally do not require a staff of analysts or a hedging strategy. High-quality bonds tend to rise and fall mostly with changes in interest rates. According to Morningstar, the average intermediate bond fund has a gross expense ratio of 1.07%. Fees are a very important factor for anyone deciding whether to purchase a particular fixed-income fund as there is a high correlation between expenses and fixed-income fund performance.
The Bottom Line
As you've seen above, fees are a very important consideration when selecting any type of mutual fund, especially fixed-income funds. It is very important to understand why a fee is high or low relative to other funds. Sometimes higher fees are justified and other times they are not. Portfolio managers and analysts should be compensated for their work. Compensation, however, should be commensurate with the effort required to manage the product and it's up to you to get involved to decide which fees—and funds—are not for you.