Economies of Scale?

ere's the theory: as the asset base of a mutual fund increases it will lower its expense ratio because of economies of scale. In practice, however, this doesn't always play out. This study examined the relationship between asset growth and expense ratios among a sample of the largest U.S. equity mutual funds over the past 20 years.

The sample of U.S. equity funds for this study started with the largest 250 U.S. equity funds (in terms of net assets) as of 6/30/2006. Of those, 124 had annual net asset and annual expense ratio data going back to 1986. Thus, 124 U.S. equity funds were included in this analysis. This particular sample of 124 prominent funds held over $1.8 trillion in total assets as of 6/30/06, or roughly 40% of the $4.468 trillion held by 4,097 distinct U.S. equity funds (and exchange traded funds) in the Morningstar Principia database as of June 30, 2006. (Distinct fund totals only count the primary share class of a multiple share class fund). Though only a small percentage of all U.S. equity funds, this sample represented a large percentage of total U.S. equity assets. Morningstar Principia was the source for all the data in this study.

As seen in "Die Hard Expense Ratios" the net assets of this sample of 124 U.S. equity funds experienced dramatic increases over the 20-year period from 1986-2005. According to theory, expense ratios should have fallen. And they did-but not by very much. However, it's difficult to say how much they "should have" declined. From a consumer's viewpoint expense ratios should have declined more. Recently, John Bogle was even more direct when he said of the mutual fund industry, "We've imposed soaring costs on our investors that belie the enormous economies of scale in money management." (The Relentless Rules of Humble Arithmetic, Financial Analysts Journal, Nov/Dec, 2005).

Die Hard Expense Ratios

The red line represents mean net assets among the 124 prominent U.S. equity funds in this study from 1986-2005. The green line tracks the median net assets of the group. The red and green line both refer to the Y-axis on the right side of the graph. The pink, yellow, and blue lines represent mean, median, and asset-weighted expense ratio for the 124 funds. The left side of the Y-axis is the scale that applies to them.

Between 1986 and 2005, mean expense ratio for this sample of prominent funds declined by 8.6%, while the median expense ratio actually increased by 3.5% (from .85% in 1985 to .88% in 2005). The asset-weighted expense ratio of these 124 funds declined almost 5.6% over the 20-year period, from .72% to .68%. Asset-weighting is a technique that weights the expense ratio of a fund proportional to its share of the total assets of all funds combined. Thus the expense ratios of larger funds are weighted more heavily inasmuch as they hold more of the assets. It is analogous to equity indexes that are market capitalization weighted. Recall that this study is focusing on a sample of the largest U.S. equity funds. Had a group of funds with smaller asset bases been selected, the findings may have been different.

During this 20-year period, median net assets of this group of funds increased by nearly 1,600% or by 1,650% if using mean asset figures. As already noted, two of the three expense ratio metrics showed slight declines of 5.6% and 8.6%, whereas one metric indicated an increase in expense ratios of 3.5% over the 20-year period.

As a general rule, the asset-weighted expense ratio is probably the most useful measurement in that it more accurately measures the "economies of scale" phenomenon. Therefore, this sample of funds experienced a modest decline of 5.6% in asset-weighted expense ratio while net assets rose 1,600%. If there are economies of scale, they are being implemented in mutual fund expense ratios at glacial speed.

In "Die Hard Expense Ratios" it is very evident that during the market declines of 2000-2002, net assets fell and expense ratios increased (by all three measures: asset-weighted, median, and mean). During a period of recovery, 2003-2005, net assets increased and expense ratios declined. Clearly, asset levels appear to have affected expense ratios in recent years. Score one for theory. However, during the six-year period from 1990-1995 expense ratios were essentially constant while net assets increased by 300% (using mean or median figures). Score one for greed.

Despite the confounding relationships between net assets and expense ratios during certain time periods, it is the case that at higher levels of net assets expense ratios tend to be lower. As seen in "Gentle Slope" there is a negative correlation between median net assets and asset-weighted expense ratios over this 20-year period. At higher asset levels, expense ratios tend to be smaller. However, we're only talking about a "bandwidth" of 12 basis points from high expense ratio to low expense ratio (.79% to .67%). The R-squared of 0.60 indicates that during this 20-year period only 60% of the movement in the expense ratio of this sample of 124 funds was explained by the net assets of the funds. (If mean, rather than median, net assets are regressed against asset-weighted expense ratio the R-squared is 0.58).

Gentle Slope

Shotgun Pattern

In the figure "Shotgun Pattern" the relationship between annual percentage changes in median net assets and the annual percentage changes in asset-weighted expense ratio is analyzed. The northwest quadrant (pumpkin color) and the southeast quadrant (light blue) represent correlations between assets and expense ratio that jibe with theory. The NW quadrant represents declines in assets and corresponding increases in expense ratio whereas the SE quadrant represents rising assets and declining expense ratios. The NW and SE quadrants also square with the notion of economies of scale.

The NE quadrant (green for greed) represents grim reality. In this quadrant are those years in which rising assets correlate with increases (or non-decreases) in expense ratios. The SW quadrant (yellow) is an area that is anti-theory because it represents falling assets and declining expense ratios. Right, like that's going to happen.

In 13 out of the 19 years (not 20 years because 1986 is the base year in the "percentage change" calculation) the correlation between changes in assets and changes in expense ratio supports the notion of economies of scale (see "Annual Scorecard"). Nine of the 13 were in the SE quadrant, wherein rising assets correlated with declines in asset-weighted expense ratios-albeit in some of the years the decline in expense ratios was very modest, such as 1995 and 2003. The poster child year was 1997 (the southern most dot in the SE quadrant). In that year, assets increased 35% and the asset-weighted expense ratio declined over 8%.

The other four years of the 13 are represented by the four dots in the NW quadrant. The specific years were 1987, 2000, 2001, and 2002. Assets fell in each of those years-in large part because of significant declines in the U.S. equity market-and in each year expense ratios increased. Apparently misery loves company.

Annual Scorecard

There were six green greed years: 1988, 1990, 1991, 1993, 1994, and 1999. In each of those years, represented by the dots in the NE quadrant, expense ratios increased in spite of rising net assets. In fact, during those six years, net assets rose by an average of 25% and expense ratios increased by an average of 2.5%. Economies of scale, where art thou?

Expense ratios are clearly affected by net asset levels. But they are also affected by decisions of the firm, and in some cases the decision is made independent of asset levels. One example is Vanguard Small Cap Index. In 1989 the expense ratio was 1.00% and its end of year assets were $33 million. At the end of 1990 its assets had grown by 39% to $46 million, but the expense ratio dropped by 69% to 0.31%. A decision was made during 1990 to lower the expense ratio. It seems clear that the decision was not made on the basis of economies of scale due to burgeoning assets.

In summary, there is evidence that the expense ratios of mutual funds are responsive to net assets-just not always in ways that are consumer friendly.

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Craig L. Israelsen, Ph.D. is an associate professor at Brigham Young University. He teaches family finance in the Department of Home and Family Living. His research interests include mutual fund analysis. He writes monthly for Financial Planning magazine. Learn more about Craig Israelsen at http://familyliving.familylife.byu.edu/faculty/israelsen.htm