Synopsis

This article explains the methodology used to stratify mutual fund expense ratios throughout the research published by Sustainable Research and Analysis. In brief, mutual funds, including sustainable as well as non-sustainable funds, are aggregated into a universe of like funds based on their investment objectives and strategies.  Taking the set of expense ratios corresponding to the universe of funds, first, second, third and fourth quartiles are calculated, along with the mean of the data set.  Funds with expense ratios in the first quartile are considered the lowest and should be preferred by investors, all other things being equal.  Funds with expense ratios in the second quartile and below the median may be acceptable also but should be considered within the context of the fund’s offering and historical total return performance.

Background

The expense ratio is one of the most important factors to be considered in the selection of an investment product such as mutual funds, ETFs, ETNs and Unit Investment Trusts (UITs), to mention just a few. The lower the expense ratio, all other things being equal, the more likely it is that the fund or similar investment vehicle (hereafter referred to as funds) will achieve market –based returns or even above market returns and more closely mirror the performance of the underlying securities market index in the case of index funds.  Expense ratios should be compared against similarly managed funds and funds with expense ratios that fall in the lowest two quintiles, all other things being equal, should generally receive the highest preference.

A fund’s expense ratio is the annual fee that mutual funds, ETFs, closed end funds and similar investment vehicles charge their shareholders or unitholders. It is expressed as the percentage of assets deducted each fiscal year for fund expenses, including 12b-1 fees, management fees, administrative fees, operating costs, and all other asset-based costs incurred by the fund.[1] At the same time, expense ratios do not include trading fees incurred by the fund, sales charges that may apply to fund purchases or ancillary account specific administration fees.  Some or all of these can also add significantly to overall fund operating expenses.

The average expense ratio for mutual funds varies according to a number of considerations. The most important ones are:  (1) whether the fund is actively or passively (index fund) managed, (2) fund type as well as complexity, that is, domestic equity funds as compared to international or global equity funds, small cap versus large cap equity funds as contrasted to bond funds and hybrid funds as well as the use of sophisticated derivative strategies and quantitative techniques, (3) retail versus institutional funds, and (4) the fund’s marketing strategy, that is to say fund firms that are attempting to establish a newly launched fund or compete for additional assets under management may elect to waive fees in order to lower expense ratios on a temporary basis and therefore improve fund performance in the near term.  For these reasons, it is often difficult to compare and contrast fund expense ratios.  Except for item 3 above, these considerations are also applicable to ETFs.

 Analysis

In research published by Sustainable Research and Analysis, expense ratios derived from mutual fund data are stratified into quartiles. This is done first by aggregating funds into a universe or population of like funds based on their investment objectives and strategies. Sustainable funds are aggregated along with their non sustainable counterparts.  This process also involves eliminating ETFs, index funds as well as distinguishing retail oriented funds from institutional funds. Retail funds are classified as such on the basis of their initial minimum investment, which must be equal to or less than $100,000.  Funds with minimum initial investments in excess of $100,000 are considered institutional funds for purposes of this analysis.  After the universe of funds is refined, their corresponding expense ratios are evaluated. Taking the universe of expense ratios, first, second, third and fourth quartiles are calculated, along with the mean of the data set.  Funds with expense in the first quartile, meaning funds in the 25th percentile or the number for which 25% of the expense ratios are fall below, are considered the lowest and should be preferred by investors, all other things being equal.  Funds with expense ratios in the second quartile and below the median may be acceptable also but should be evaluated within the context of the fund’s overall profile, including its strategy and performance.

In research published by Sustainable Research and Analysis, fund expense ratios are classified, as follows:

 

 

 

Illustration:  Investment Grade Bond Funds

Investment grade bond funds have been aggregated into a universe of like funds based on their investment objectives and strategies and the corresponding skills and expertise required to manage such funds, including a credit research function. Investment grade funds include corporate bond funds, long-term, intermediate-term as well as short-term funds.  ETFs and index funds have been excluded from consideration.  According to data as of March 31, 2017, 468 funds fall into this combined category with expense ratios that range from a low of 0.00% to a high of 2.37%[2].  The median expense ratio (that is, 50% of the expense ratios are below this number and 50% of the expense ratios are above this number) for this universe of funds is calculated to be 0.78%.  In turn, the lowest quartile or the 25th percentile which is the number for which 25% of the values in the data set are smaller, is 0.56%.  The highest quartile or the 75th percentile that is the number beyond which 25% of the values are highest is calculated to be 1.1%. Outlying funds are excluded. This is illustrated below.  See Exhibit 1.

Exhibit 1: Investment Grade Bond Funds-Quartile Ranking of Expense Ratios

 

 

 

 

 

 

 

[1] Source:  Steele/Morningstar mutual fund data as of March 31, 2017

[2] Expense ratios exclude trading costs, sales charges as well as account specific administrative charges, if any, that may be applied in addition to the fund’s expense ratio.