Buyers of funds seeing fees fall

Index investing upends industry

NEW YORK — The amount of money being invested in the cheapest mutual funds and exchangetraded funds is leading to lower fees as the more expensive funds cut expenses to compete.

Investors are increasingly heeding experts’ advice to seek out lower-cost funds in their 401(k) accounts and other portfolios. And because so much money is massing in the cheapest funds, the pressure is on the rest of the industry to cut their own expenses or risk losing even more dollars.

The result of this heightened cost consciousness: Investors are keeping more of their own dollars and possibly setting themselves up for better returns in the future.

The steady drip lower for expenses means $63 of every $10,000 invested in stock mutual funds went to cover fees last year. That’s down from $67 a year earlier and from $104 two decades ago, according to figures published recently by the Investment Company Institute, an industry group. Bond funds have seen a similar drop in fees: The average cost has dropped to $51 from $84 of every $10,000 invested over the

past two decades.

A separate study released by Morningstar last week found the same trend: Investors paid lower expenses last year than ever before for their mutual funds and exchange-traded funds, on average.

One of the biggest drivers is the exploding popularity of index funds and exchange-traded funds, which boast some of the lowest expenses in the industry. Many investors have given up on trying to find star fund managers who can deftly pick the right stocks and bonds to beat the rest of the market. Instead, they’re fine with riding funds that merely track the movements of the Standard & Poor’s 500 and other indexes.

Because index funds don’t have to hire teams of stock pickers and other market analysts, and because they’re all trying to do roughly the

same thing, these funds typically compete on price, and that price has been inching closer to zero.

Schwab and iShares have exchange-traded funds that track the broad U.S. stock market with expense ratios of just 0.03 percent, for example. That means $3 of every $10,000 invested goes to cover fees.

As a group, index funds have an average expense ratio of 0.17 percent, according to Morningstar. Actively managed funds, which are the ones run by managers that are trying to beat the market, have an average expense ratio more than quadruple that, at 0.75 percent.

Having low expenses is one of the best predictors for a fund’s relative future performance, analysts say. That’s because a fund that charges 0.75 percent has to perform just about that much better to produce the same returns as a fund with a 0.03 percent expense ratio. The cheaper fund begins the race with a built-in head

start.

Investors have noticed, and they pulled $340 billion out of actively managed funds last year. At the same time, nearly $505 billion went into index funds.

But one small group of actively managed funds is managing to buck the trend: the cheapest ones. Actively managed funds with fees that rank in the cheapest 20 percent attracted $41 billion in net investment over the past two years. The other 80 percent of actively managed funds, meanwhile, saw $627 billion leave over the same time, according to Morningstar.

It’s a relatively new trend. As recently as 2013, investors were putting money into actively managed funds broadly, not just the cheapest 20 percent. The split has become more pronounced in each of the following three years.

One warning: Read the label closely when a fund advertises its “below-average” fees. That’s because, like

much in investing, calculating the average fee can be a complicated affair, and many more than half of all funds can make the claim.

The simple average expense ratio of all funds was 1.14 percent last year. So anyone with a 1 percent expense ratio could tout having a “below-average” fee.

But because investors have flocked in such droves to cheaper funds, the average expense ratio was only 0.57 percent, if you give more weight to funds with bigger assets.

This asset-weighted approach is how the Investment Company Institute, Morningstar and other analysts prefer to look at the market. Less than 10 percent of all money invested in funds was in one that had an expense ratio above 1.14 percent.

So even though following the herd is rarely a good idea in investing, this time really may be different. Staying with the cheap crowd can pay off.