Professor’s Reading Room

July 01, 2005

Excessive mutual fund ex penses also mean higher risk and worse performance

It is no secret that mutual fund expenses are high, and it has been demonstrated that compounding fund expenses over time has a significant impact on realized returns. Unfortunately, this sad tale of negative drag is only half the story. On further analysis, funds with excessive expense ratios also have negative portfolio characteristics, including higher risk, higher trading costs and lower earnings. In other words, investors in these funds are getting hit twice: They're paying high fees while getting poor performance and risky portfolios in return.

Method And Sample

Our study looked at all of the domestic equity mutual funds listed in the Morningstar Principia database. The sample comprises 6,179 funds. For our purposes, each share class of an independent mutual fund is classified as its own "fund"; for funds with no share classes, the entire fund counts as one "fund."

The total sample is split into nine sub-samples, one for each of the Morningstar categories. Each Morningstar category represents a two-way combination of market capitalization (large cap, mid-cap or small cap) and investment style (growth, blend or value).

The study selected for mutual funds with management fees and expense ratios above both the means of their Morningstar categories and the overall average. The analysis is cross-sectional, and the individual "fund" cost ratios are unweighted, as each fund represents the actions of individual decision units.

The study characterized the degree to which fund expense ratios were "excessive" by separating funds into four classes based on their standard deviation above the relevant Morningstar average.

The mutual fund expense ratios are identified as: (1) above average, (2) excessive, (3) very excessive and (4) most exce ssive. The first standard deviation class identifies funds with expense ratios that exceed the mean by less than one standard  deviation. The other three standard deviation classes identify fund expense ratios that exceed the means of their Morningstar categories by one, two and three standard deviations, respectively.

Similarly, funds with average or lower than average expense ratios were also characterized by standard deviation: 1) average, 2) below average and 3) well below average.


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