Right Incentives, Wrong Incentives

The devil did his job. He took the hindmost. In the six months between the end of June and the end of December, the mutual fund population fell by 499 from 23,920.

Should we shed a tear?

I think not. While it tells us that we aren’t the only folks in pain, it’s just a sign that too many fund managers were trying to feed on our money, and some were crowded out.

The biggest shrinkage was in ultra-short bond funds. Their number fell by 25 percent. As with money market funds, it’s hard to survive when short-term interest rates aren’t high enough to pay fund expenses, let alone pay shareholders.

That’s one of the lessons from my second Fat Fund Report, a periodic examination of mutual funds that focuses on the distribution of expense ratios and their relationship to performance. In this report I’ve expanded the number of fund categories from 17 to 20, including every category that has at least 250 funds with a history of 3 years or longer.

Are there any new revelations?

Nope. As before, there is great variation in the expenses mutual fund funds charge their shareholders. While many of the differences are explained by how the fund is distributed (no-load, deferred-load, etc.), the end reality is that you and I have a choice when we buy mutual funds. One of the most important considerations is how much it costs to manage the fund.

The largest fund category is what Morningstar calls “large blend” funds. These are funds that invest in a broad mix of large capitalization domestic stocks. They are usually benchmarked against the Standard & Poor’s 500 index. There, we see that funds in the least expensive 10 percent had expense ratios of 0.50 percent or lower, while funds in the most expensive 10 percent cost 2.05 percent or more. Funds in the least expensive 25 percent had expense ratios of 0.85 percent or lower, while funds in the most expensive 25 percent cost 1.64 percent or more.

The difference is all money in their pockets, not yours. Examine the figures in the table below and you’ll find that you’ll pay about 2.5 times as much for a most expensive decile fund as for a least expensive decile fund.

Buy a car that costs 2.5 times as much as the least expensive car and you’ll be able to name a long list of amenities and performance benefits. You’ll have the same experience with the purchase of an expensive suit versus a cheap suit and with many other goods and services. In most of the real world, you pay for quality and performance.

It doesn’t work that way in the mutual fund world. It never has. There, the more you pay in fund expenses, the greater the odds your long-term performance will suffer.

Indeed, the single best tool for selecting a mutual fund is its expense ratio. The lower the ratio, the higher the probability you’ll enjoy above-average performance. The table below shows the expense ratio for each fund group at five different points— the least and most expensive decile, the least and most expensive quartile, and the median. Over the last three years, the average fund in the least expensive decile has provided a higher performance than the average fund in the most expensive decile. The greatest advantage, 4.5 percent annualized, was in diversified emerging markets— the most volatile fund category. More typical advantages were in the range of 1.5 to 2 percent a year.

So allow me to suggest a simple two-step way to improve your portfolio.

  • First, check the category and expense ratio for each of your funds. If the expense ratio is in the most expensive quartile, make it a candidate for sale. Remember, all you have to do is replace it with a fund that has a low expense ratio and you’ll increase the odds of superior performance in a big way.
  • Second, visit www.mutualfundobserver.com, and find out if your fund is a one-, two- or three-alarm fund— having trailed its index for one, two or three time periods. If any alarms are sounded, replace the fund. And don’t be afraid to replace it with an index fund. Why? Because they are generally in the lowest-cost decile.

    Prospectus Net Expense Ratios Performance
Morningstar Category # 3 yr funds 10th 25th 50th 75th 90th 10-90 Spread
Large blend 1789 0.50 0.85 1.21 1.64 2.05 0.98
Large growth 1559 0.80 1.00 1.27 1.72 2.09 1.32
Large value 1123 0.71 0.95 1.21 1.60 1.96 1.41
Mid-Cap growth 737 0.91 1.11 1.36 1.77 2.18 0.96
Small growth 678 1.02 1.16 1.48 1.94 2.30 2.12
Foreign Large Blend 642 0.83 1.15 1.45 1.87 2.27 1.47
Small blend 579 0.70 1.06 1.38 1.75 2.24 1.60
World Stock 545 0.97 1.36 1.53 2.10 2.34 2.31
Mid-Cap blend 382 0.56 1.04 1.37 1.78 2.22 1.95
Mid-Cap value 366 0.85 1.05 1.29 1.64 2.10 1.14
Small value 317 1.00 1.20 1.45 1.87 2.23 2.36
Divers. Emerging Mkts. 265 1.10 1.43 1.80 2.14 2.62 4.50
Foreign Large Value 277 0.81 1.05 1.37 1.76 2.25 1.71
  Average= 0.83 1.11 1.40 1.81 2.22 1.83
Mixed Portfolios              
Moderate Allocation 953 0.78 1.03 1.28 1.80 2.06 0.64
Conservative Allocation 522 0.80 0.98 1.21 1.64 1.91 0.86
  Average= 0.79 1.01 1.25 1.72 1.99 0.75
Fixed Income              
Intermed-Term Bond 999 0.49 0.67 0.90 1.27 1.67 2.01
High Yield Bond 475 0.74 0.87 1.10 1.65 1.86 1.57
Short-Term Bond 384 0.48 0.66 0.85 1.18 1.59 0.10
Intermed Government 345 0.51 0.71 0.94 1.49 1.71 2.20
National-long 255 0.56 0.74 0.88 1.45 1.64 2.08
  Average= 0.56 0.73 0.93 1.41 1.69 1.59

The complete Fat Fund report is available as a PDF download at www.assetbuilder.com/fatfund.

On the web:

The first Fat Fund Report Column

The PDF download for the previous Fat Fund Report