When Assets Rise, Expenses May Drop

By RUSS WILES

June 23, 1996 12 AM PT

RUSS WILES, a financial writer for the Arizona Republic, specializes in mutual funds

As mutual funds grow in size, they are supposed to pass along some cost savings to their shareholders.

Many of the services that funds spend money on--legal advice, accounting help and even portfolio management--are fixed in nature. So by expanding its asset base, a fund should be able to achieve economies of scale.

That’s the ideal, anyway. In reality, it does not always work that way. Fund companies do an erratic job of shaving expenses as their portfolios grow, according to a recent survey by Morningstar Inc.

The Chicago research firm set out to learn whether several big fund groups charged lower expenses on their large funds. Morningstar examined costs on broadly diversified stock funds with less than $500 million in assets, those above $1.5 billion and others between the two extremes.

The presumption was that “expense ratios,” which measure a fund’s total costs divided by the number of its outstanding shares, would be lower for the larger funds.

For certain families, it turned out that way. At several big load-fund groups such as Merrill Lynch, Dean Witter and Oppenheimer, expenses on large funds were sharply lower than those on small ones.

Oppenheimer’s small funds, for example, averaged nearly 1.5% in annual expenses, while its large portfolios came in below 1%. Dean Witter’s costs declined from about 2.2% for funds with less than $500 million in assets to below 1.6% on portfolios of $1.5 billion or more.

Merrill Lynch’s average costs eased from about 1.1% for small funds to below 0.6% on large portfolios, making them cheaper than those of several no-load outfits.

In short, Morningstar found that the load groups tended to charge higher costs on their smaller funds compared with their no-load rivals but that their products became more competitive as their assets increased. The study ignored the impact of front- and back-end sales charges, which are not counted in a fund’s expense ratio.

Average expenses on no-load funds tended to cluster more tightly, and they didn’t fall as much as fund assets expanded--in part because they did not have as far to fall.

In Morningstar’s view, investors need to look at expenses on a family-by-family basis to find out if firms are achieving economies of scale.

“Some families work hard to pass savings on to shareholders, while others do not,” wrote analyst Jeff Kelley in the May issue of the Morningstar Investor newsletter.

But Morningstar’s survey itself may be open to some criticism. One problem with the study is that it does not relate fees to performance. Certain fund families have incentive-pay arrangements, which allow them to charge higher management fees when they earn superior returns but requiring them to accept lower fees if returns lag.

This explains why Fidelity Magellan charges higher management fees and overall expenses than, say, the much smaller Fidelity OTC Portfolio, which has not fared as well, says company spokeswoman Robyn Tice.

Morningstar’s take on Fidelity is that the firm does reduce expenses on some funds as they get larger but that it doesn’t cut costs “systematically or drastically.”

Another flaw of Morningstar’s study is that it does not take into account the number, type and age of funds at various asset levels, says Vanguard spokesman Brian Mattes.

Morningstar noted a peculiarity about Vanguard: Its costs beat those of the competition across the board, yet bigger Vanguard funds were slightly more expensive than smaller Vanguard funds.

The explanation, says Mattes, is that Vanguard’s largest stock funds tend to be higher-cost, actively managed portfolios, whereas most of its lower-cost index funds are relatively young and thus still small.

The Morningstar study, he says, should be viewed as a snapshot for a family’s fees at one point in time.

“It isn’t true that as our fund assets increase, our expenses go up,” Mattes said.

The upshot of the Morningstar study is that investors should favor fund groups that pass along economies of scale. But investors also need to look beyond the raw expense numbers, checking for incentive-pay policies and interpreting the data with an eye on the types of funds offered.

Scudder, Stevens & Clark Inc. announced last week that the Scudder Funds are now available to investors through Schwab OneSource. All Scudder income and equity funds will be available, with the exception of the Latin America Fund and the Japan Fund.

The PBHG Emerging Growth Fund has reopened its doors to new investors after a one-year hiatus. Assets of the Wayne, Pa.-based fund vaulted 48% in 1995. The no-load fund ([800] 809-8008, $2,500 minimum) focuses on small stocks.

The Vanguard Group has introduced a foreign index fund that provides entry to most major international markets by investing in three other Vanguard portfolios.

The Vanguard Total International Portfolio takes in more than 1,500 stocks in 31 nations. About 44% of its assets are earmarked to Europe, 44% to East Asia and 12% to emerging markets. Expenses for the new fund ([800] 662-7447) are expected to run 0.38%, or $3.80 for each $1,000 stake. The minimum investment is $3,000, with a 1% transaction fee and a $10 annual account maintenance fee.

Twentieth Century and Benham, which last June teamed up in one of 1995’s largest fund company mergers, have unveiled three Strategic Asset Allocation funds--the first products to issue from the marriage.

Benham’s bond experts and Twentieth Century’s stock managers will run the portfolios. The most conservative of the funds will normally keep 40% of assets in stocks, 45% in bonds and 15% in cash. The most aggressive will have 75% in stocks, 20% in bonds and 5% in cash.

The no-load funds ([800] 345-2021 and [800] 331-8331) require a minimum $2,500 investment, though that requirement will be waived if an automatic investment program is established.

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Passing Along Savings?

Do mutual fund groups reduce expenses as their funds grow in size? Here’s how Morningstar Inc. evaluates the cost-cutting efforts of several leading firms:

* American Funds: Hard to tell. All equity funds are already big and cheap.

* Dean Witter: Steep cuts but still expensive because of preponderance of Class B shares.

* Dreyfus: Wide range in costs, even among largest funds.

* Fidelity: Costs vary, without clear advantage to larger funds.

* Janus: Among largest funds, Janus Mercury ups the average.

* Merrill Lynch: Largest funds quite cheap. Class B, C shares more dear.

* Oppenheimer: Pricey small funds. Largest funds get more reasonable.

* T. Rowe Price: Nice cuts in small and mid-cap funds. Flat after $1 billion.

* Putnam: Class B shares pricier, but A shares cost just more than 1%.

* Scudder: Respectable effort to lower expenses on larger funds.

* Twentieth Century: Large or small, all funds cost about 1% a year.

* Vanguard: Don’t complain! Still the cheapest across the board.