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A LETTER FROM ICI'S
CHIEF ECONOMIST

ICI RESEARCH:
STAFF AND PUBLICATIONS

SECTION 1:
OVERVIEW OF
U.S.-REGISTERED INVESTMENT COMPANIES

SECTION 2:
RECENT MUTUAL FUND TRENDS

SECTION 3:
EXCHANGE-TRADED FUNDS AND INDEX MUTUAL FUNDS

SECTION 4:
CLOSED-END FUNDS

SECTION 5:
MUTUAL FUND FEES AND EXPENSES

SECTION 6:
CHARACTERISTICS OF MUTUAL FUND OWNERS

SECTION 7:
THE ROLE OF MUTUAL FUNDS IN RETIREMENT AND EDUCATION SAVINGS

DATA TABLES

APPENDIX A:
HOW MUTUAL FUNDS AND INVESTMENT COMPANIES OPERATE

APPENDIX B:
ICI STATISTICAL RELEASES AND RESEARCH PUBLICATIONS

TIMELINE:
SIGNIFICANT EVENTS IN FUND HISTORY

FACT BOOK ARCHIVE

Mutual fund investing involves two primary kinds of fees and expenses: sales loads and ongoing expenses. Sales loads are one-time fees—paid directly by investors either at the time of share purchase (front loads) or, in some cases, when shares are redeemed (back-end loads). Ongoing fund expenses cover portfolio management, fund administration, daily fund accounting and pricing, shareholder services such as call centers and websites, distribution charges known as 12b-1 fees, and other miscellaneous costs of operating the fund. Unlike sales loads, ongoing expenses are paid from fund assets and thus investors pay them indirectly. A fund's expense ratio is its annual ongoing expenses expressed as a percentage of fund assets.

Trends in Mutual Fund Fees and Expenses

To understand trends in mutual fund fees and expenses, it is helpful to combine major fund fees and expenses in a single measure. ICI created such a measure by adding a fund's annual expense ratio to an estimate of the annualized cost that investors pay for one-time sales loads. This measure gives more weight to those funds that have the most assets.

Mutual fund fees and expenses that investors pay have trended downward since 1980. In 1980, investors in stock funds, on average, paid fees and expenses of 2.32 percent of fund assets. By 2007, that figure had fallen by more than half to 1.02 percent (Figure 5.1). Fees and expenses paid on bond funds have declined by a similar amount.

There are several reasons for the dramatic drop in the fees and expenses incurred by mutual fund investors. First, investors generally pay much less in sales loads than they did in 1980. For example, the maximum front load that an investor might pay for investing in an equity fund has fallen from an average of 8.0 percent of the investment in 1980 to 5.3 percent in 2007. The front loads that equity fund shareholders actually paid have fallen even more, from 5.6 percent in 1980 to only 1.2 percent in 2007. A key factor in the steep decline in loads paid has been the growth of mutual fund sales through employer-sponsored retirement plans. Load funds often do not charge loads for purchases of fund shares through such retirement plans.

Another reason for the decline in the fees and expenses of investing in mutual funds has been the growth in sales of no-load funds. Much of the increase in sales of no-load funds has occurred through the employer-sponsored retirement plan market. Sales of no-load funds have also expanded through mutual fund supermarkets and discount brokers.

Finally, mutual fund fees have been pushed down by economies of scale and intense competition within the mutual fund industry. The demand for mutual fund services has increased dramatically since 1980. From 1980 to 2007, the number of households owning mutual funds rose from 4.6 million to 50.6 million and the number of shareholder accounts rose from just 12 million to about 300 million. Ordinarily, such a sharp increase in the demand for fund services would have tended to limit decreases in fund expense ratios. This effect, however, was more than offset by the downward pressure on fund expense ratios from competition among existing fund sponsors, the entry of new fund sponsors into the industry, and economies of scale resulting from the growth in fund assets.

Figure 5.1

Fees and Expenses Incurred by Stock and Bond Mutual Fund Investors have Declined Since 1980

(percent, selected years)

Download an Excel file of this data.

1asset-weighted average of annual expense ratios and annualized loads for individual funds
2Data are preliminary.
Sources: Investment Company Institute; Lipper; ValueLine Publishing, Inc.; CDA/Wiesenberger Investment Companies Service; © CRSP University of Chicago, used with permission, all rights reserved (312.263.6400/www.crsp.com); and Strategic Insight Simfund

Shareholder Demand for Lower-Cost Funds

ICI research indicates that mutual fund shareholders invest predominantly in funds with low expense ratios. This can be seen by comparing the average expense ratio on mutual funds offered in the marketplace with the average expense ratio mutual fund shareholders actually paid (Figure 5.2). The simple-average expense ratio of stock funds (which measures the average expense ratio of all stock funds offered in the market) was 1.46 percent in 2007. The average expense ratio that stock fund shareholders actually paid (the asset-weighted average expense ratio across all stock funds) was considerably lower, just 0.86 percent of fund assets. Thus, investors actually paid expense ratios at the lower end of the range of funds available in the market.

Figure 5.2

Fund Shareholders Pay Lower-Than-Average Expenses in Stock Funds

(percent, 1993–2007)

Download an Excel file of this data.

1Variable annuities are excluded.
2asset-weighted average of annual expense ratios for individual funds
3 Data are preliminary.
Sources: Investment Company Institute; Lipper; ValueLine Publishing, Inc.; CDA/Wiesenberger Investment Companies Service; © CRSP University of Chicago, used with permission, all rights reserved (312.263.6400/www.crsp.com); and Strategic Insight Simfund

Another way to illustrate that investors demand mutual funds with low expense ratios is to identify how investors allocate their new purchases of mutual fund shares. During the 10-year period from 1998 to 2007, the vast majority of net new cash flowing to stock funds went to those funds whose expense ratios were below the market average (Figure 5.3). This was true for both actively managed funds and index mutual funds.

Figure 5.3

Stock Funds with Below-Average Expense Ratios Receive 91 Percent of Net New Cash*

(percent, 1998–2007)1

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*Variable annuities are excluded; based on preliminary data for 2007.
Sources: Investment Company Institute; Lipper; ValueLine Publishing, Inc.; CDA/Wiesenberger Investment Companies Service; © CRSP University of Chicago, used with permission, all rights reserved (312.263.6400/www.crsp.com); and Strategic Insight Simfund

Factors Influencing Mutual Fund Fees and Expenses

As is true of the prices of most goods and services, fees differ considerably across the range of mutual funds (Figure 5.4). The level of fund fees depends on the fund investment objective, fund assets, balances in shareholders accounts, the number and kinds of services that a fund offers, and other factors.

Fund Investment Objective. Expenses vary by type of fund: for example, bond and money market funds tend to have lower expense ratios than equity funds. Among equity funds, expense ratios tend to be higher among funds that specialize in particular sectors ("Sector" funds) such as health care or real estate, or those that invest in international stocks, which tend to be more costly to manage than, for instance, stocks in the S&P 500 index.

Even within a particular type of fund, there can be considerable variation in fund expense ratios. For example, expense ratios for aggressive growth equity funds range from less than 0.90 percent to more than 2.24 percent. Such variation in part reflects the fact that such funds are not all identical. Some aggressive growth funds may choose to focus more on small- or mid-cap stocks while others may focus more on large-cap stocks. This can be significant because small- and mid-cap stocks tend to be more costly to manage.

Figure 5.4

Expense Ratios for Selected Investment Objectives*

(percent, 2007)

Download an Excel file of this data

*Data are preliminary; variable annuities are excluded
Sources: Investment Company Institute; Lipper; © CRSP University of Chicago, used with permission, all rights reserved (312.263.6400/www.crsp.com); and Strategic Insight Simfund

Fund and Average Fund Account Size. Other factors—such as fund size and fund account size—also help explain differences in fund expense ratios.

All else equal, large mutual funds tend to have lower-than-average expense ratios because of economies of scale. Fund sizes vary widely across the industry. In 2007, the median long-term mutual fund had assets of $246 million (Figure 5.5). Twenty-five percent of all long-term funds had assets of $71 million or less, while another 25 percent of long-term funds had assets greater than $856 million.

Funds with higher account balances also tend to have lower expense ratios than other funds. This reflects the fact that each account, regardless of how large or small it is, requires a given, relatively fixed level of service. For example, account statements must be mailed periodically to account holders. Funds that cater primarily to institutional investors—who typically invest large amounts of money in fewer accounts—tend to have high average account balances. Many funds primarily serve retail investors, who typically have lower average account balances. In part because of this, account balances, like fund sizes, range considerably across the industry. In 2007, 50 percent of long-term funds had average account balances of less than $47,029. Twenty-five percent of long-term funds had average account balances of less than about $20,000. At the other extreme, 25 percent of funds had average account balances of more than $160,000.

Payments to Intermediaries. Another factor that helps explain variation in fund fees is whether funds are sold through intermediaries such as brokers or registered financial advisers. These professionals help investors define their investment goals, select appropriate funds, and provide ongoing advice and service. Financial advisers are compensated for these services, in part, through a particular kind of fund fee, known as a 12b-1 fee, which is included in a fund's expense ratio. Funds sold through intermediaries tend to have higher expense ratios than other funds (no-load funds). No-load funds are sold directly to investors or are sold to investors through financial advisers who charge investors directly for investment advice. Thus, no-load funds tend to have lower expense ratios than other funds with similar investment objectives.

Figure 5.5

Fund Sizes and Average Account Balances Vary Widely

(long-term funds, excluding variable annuities, year-end, 2007)

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Note: Number of shareholder accounts includes a mix of individual and omnibus accounts.

A LOOK AT THE FEES AND EXPENSES OF S&P 500 INDEX MUTUAL FUNDS

There are more than 8,000 mutual funds available to investors, and no two are identical. Mutual funds vary in terms of size, investment objective, and the services they provide to shareholders and, consequently, in the fees and expenses that they charge.

For example, all S&P 500 funds share the goal of mirroring the return on the S&P 500 index, a well-known index of 500 large-cap stocks. As a result, S&P 500 index mutual funds all hold essentially identical portfolios.

Nevertheless, S&P 500 funds differ from one another in important ways. Some S&P 500 funds are very large—among the largest of any mutual funds—while other S&P 500 funds are quite small. Required minimum investments range widely for S&P 500 index funds, from $100 for some retail funds to more than $25 million among S&P 500 funds that cater to institutions. S&P 500 funds also differ in terms of certain fees that investors may pay out-of-pocket, such as account maintenance fees. Finally, some S&P 500 funds are sold through intermediaries (load funds), while others are not (no-load funds).

Figure 5.6

Investor Assets Are Concentrated in S&P 500 Index Mutual Funds With the Lowest Expense Ratios*

(percent of total assets of S&P 500 index mutual funds, 2007)

Download an Excel file of this data.

*Data are preliminary.
Note: Percentages may not add to 100 percent because of rounding.
Sources: Investment Company Institute and Lipper

Because S&P 500 index funds are not all identical, their expense ratios differ. Large funds and funds with high average account balances tend to have lower-than-average expense ratios because of economies of scale. Funds sold through intermediaries tend to have higher expense ratios than comparable no-load funds in order to compensate financial advisers for the planning, advice, and ongoing service that they provide to clients. Retail investors who purchase no-load funds either do not use a financial adviser or use a financial adviser but pay the adviser directly.

Investors favor the least costly S&P 500 funds. For example, in 2007, the great majority of assets that investors held in S&P 500 index funds were held in low-cost funds, those with expense ratios of 20 basis points or less (Figure 5.6). Similarly, low-cost funds have garnered the bulk of investors' net new purchases of shares of S&P 500 index mutual funds. From 1998 to 2007, more than 80 percent of the total net new cash flow to S&P 500 funds went to those funds with expense ratios of 20 basis points or less (Figure 5.7).

Figure 5.7

Investors' Net Purchases of S&P 500 Index Mutual Funds Are Concentrated in Least Costly Funds*

(percent of net new cash flow of S&P 500 index mutual funds, 1998–2007)

Download an Excel file of this data.

*Data are preliminary.
Note: Percentages may not add to 100 percent because of rounding.
Sources: Investment Company Institute and Lipper

Rule 12b-1 Fees

Many mutual fund investors use and pay for the services of a professional financial adviser. ICI research finds that among investors owning mutual fund shares outside of retirement plans at work, 80 percent own fund shares through professional financial advisers. Financial advisers typically devote time and attention to prospective investors before they make an initial purchase of funds and other securities. The adviser generally meets with the investor, identifies financial goals, analyzes existing financial portfolios, determines an appropriate asset allocation, and recommends funds to help achieve the investo's goals. Advisers also provide ongoing services, such as periodically reviewing investors' portfolios, adjusting asset allocations, and responding to customer inquiries.

Until about 25 years ago, fund shareholders could only compensate financial advisers for their assistance through a front load—a one-time, upfront payment made to financial advisers for both current and future services. After 1980, when the U.S. Securities and Exchange Commission (SEC) adopted Rule 12b-1 under the Investment Company Act of 1940, funds and their shareholders had greater flexibility in compensating financial advisers. The adoption of this rule, and subsequent regulatory action, established a framework under which mutual funds pay for some or all of the services that financial advisers provide to shareholders through so-called 12b-1 fees. This framework also allows mutual funds to use 12b-1 fees to compensate other financial intermediaries, such as retirement plan recordkeepers and discount brokerage firms, for services provided to fund shareholders, and to pay for advertising, marketing, and other sales promotion activities.

Nevertheless, most of the 12b-1 fees collected by funds are used to compensate financial advisers and other financial intermediaries for assisting fund investors before and after purchases of fund shares (Figure 5.8). Furthermore, only a small fraction (2 percent) of the 12b-1 fees that mutual funds collect is used for advertising and promotion.

Figure 5.8

Most 12b-1 Fees Used to Pay for Shareholder Services

(percent of 12b-1 fees collected, 2004)

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Source: Fundamentals, "How Mutual Funds Use 12b-1 Fees"

The amount of 12b-1 fees that shareholders pay through mutual funds rose from a few million dollars in the early 1980s to about $13 billion in 2007 (Figure 5.9). This increase reflects, in part, the nearly 90-fold increase in mutual fund assets and the 11-fold increase in the number of households owning funds since 1980. The increase in total 12b-1 fees also reflects a shift by mutual funds and their investors from front loads to 12b-1 fees as a mechanism to compensate financial advisers. As funds have added 12b-1 fees, the typical maximum front load on all long-term funds declined from 8.0 percent in 1980 to about 4.9 percent in 2007. Most load funds now also offer classes of shares that have 12b-1 fees but no front loads.

For more information on fund operations and the fees and expenses that funds charge, see Appendix A: How Mutual Funds and Investment Companies Operate. ICI also offers an investor education brochure explaining mutual fund fees and expenses.

Figure 5.9

Rise in 12b-1 Fees Paid Reflects Asset Growth and shift in Source of Financial Advisers' Compensation

(billions of dollars, selected years)

Download an Excel file of this data.

*Data are preliminary.
Note: Variable annuites are excluded.
Sources: Investment Company Institute; Lipper; © CRSP University of Chicago, used with permission, all rights reserved (312.263.6400/www.crsp.com); and Strategic Insight Simfund