It's that simple.
Baylor University economist William Reichenstein, along with University of Saskatchewan finance professor Dale L. Domian, remind us of this basic fact in the current Journal of Investing.
In an efficient market, they say, the bond fund with the lower expense ratio will have a net return advantage over a bond fund with a higher expense ratio. In addition, every dime of greater expense should reduce the net return by the same amount. Similarly, any front-end load will also be a "deadweight loss." Extending Professor Reichensteins' work on taxable bond funds a few years ago, this article tests the same idea on tax-free bond funds.
And I'll bet you aren't a tiny bit surprised at what they found!
Tax-free bond funds with high expenses have poorer performance than tax-free bond funds with low expenses. The connection appears to be very direct: add expenses and returns to shareholders decline.
There was a time when this could be ignored. When yields were much higher, high expense ratios on mutual funds were blown off as irrelevant or the "price of good management." After all, when yields are 10, 11, and 12 percent--- as they were in the late 70's and very early 80's--- one percent in expenses wasn't so terrible. It was a tenth of the investment income, sometimes less.
Today, things are different.
You can get some idea of the impact of fees in the past by examining the table below. It shows the returns offered by the universe of 186 intermediate term national tax-free bond funds over periods ranging from 8 months to 15 years. The low cost funds are those with expense ratios that are below average. The high cost funds are those with expense ratios that are above average. As you can see, in every period, the low cost fund provided a higher return than the high cost fund.
|In Tax-Free Funds, Expenses Matter|
|The low cost fund group contains all funds with expense ratios below the average of 0.89 percent. The high cost fund group contains all funds with expense ratios above the average of 0.89 percent.|
|Period||Avg. Low Cost||Average||Avg. High Cost|
|Avg. Expense Ratio||0.63||0.89%||1.33|
|Source: Morningstar Principia, August 31 data|
The 1.33 percent average expense ratio of the high cost funds, for instance, would take 27.5 percent of portfolio income from today's 30-year bond. It would take 50 percent of portfolio income from today's 5-year bonds. Of the 1,805 municipal bond funds in operation, 772 have annual expense ratios of 1 percent or more.
This situation isn't limited to tax-free bond funds.
With Treasury and mortgage yields at historic lows, any fund with a high expense ratio is likely to be endangered by outflows of assets. Shareholders will look for better treatment. In the universe of 2,423 mutual funds that invest in taxable bonds 1,062 have expense ratios of 1.0 percent or more. In other words, more than 40 percent of all bond funds have annual expenses of 1.0 percent or more--- in an environment of very low interest rates.
What does this mean for you and me?
First, we need to check the expense ratio of the fixed income funds we own. If it's high, we need to move our money to a fund that respects the shareholder.
Second, the mutual fund industry is heading for a major consolidation. Just as shrunken equity funds are being folded into larger funds to cut costs, we're going to see hundreds of fixed income funds closed or folded into other funds.
The mutual fund industry has a new mission: reduce costs to a level investors will bear.