Mutual Fund Expenses Should Go Down And Not Up
May 15, 2008 – 8:04 amI think it’s interesting that the mutual fund industry is one of the few industries that doesn’t adjust it’s cost structure for economies of scale.
In manufacturing, the more of something you produce the less expensive it becomes. It’s called leverage, and because of machines, purchasing power, and technological advancement large firms require less people in order to produce their products.
Although large mutual fund companies take advantage of reduced costs from an overhead (i.e. administrative staff) perspective, I don’t see any of these savings being passed on to the consumers.
Take an index fund for example. You would think that an index fund with 20 billion in assets would be less expensive to run, on a percentage basis, than an identical index fund that has only 10 million in assets. Likewise, as that 20 billion grows to 40 billion over say ten years (without any new investments being made), the expense ratio of the fund remains the same. Through this methodology it looks like mutual fund companies expenses, in total dollar terms, will increase the same percentage as the overall market. What a deal! At 10% annual return you’ll be paying the same expense ratio (say 0.2% for example), on assets that are now 10% larger this year than they were last year.
Here’s an example:
- Investment: $10,000
- Expense Ratio: 1%
- Expenses Paid this year: $100
At the end of the year, your 10,000 is now worth $11,000 assuming a 10% return and no tax consequences.
In the second year here’s what the scenario looks like:
- Investment: $11,000
- Expense Ratio: 1%
- Expenses Paid this year: $110
That’s a 10% increase in expenses from one year to the next, the same increase percentage as the market’s return!
So I ask, where are the efficiencies? Most of us are so glad to see the 10% return in a single year we forget about the “extra” $100 the fund company will take next year, regardless of whether we make or lose money with our investments in year 2. I understand businesses are here to make a profit for shareholders (except Vanguard, which is member-owned). But I would expect some level of efficiency to get passed on the the consumers…ME! I know the market does go down as well as up, but over time it goes up. Does it really take 10% more people, electricity, rent, insurance, and so on to manage 10% more money? I don’t think so.
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