Identification and Performance of Equity Mutual Funds with High Management Fees and Expense Ratios

Abstract

Because strong price competition does not characterize the mutual fund industry, we conclude that fund expenses are too high. This conclusion is consistent with the study's empirical findings that very large and significant differences exist among specifically identified funds with respect to management fees and expense ratios. Yet, there remains the question of "so what" if mutual fund expenses are too high? No one forces investors to choose funds. We find the answer in the Investment Company Act of 1940 and its requirement that independent directors have a "fiduciary duty" with respect to the reasonableness of fund fees.

We identify 67 specific mutual funds with statistically very high and 23 funds with extremely high management fees. In addition, we identify 66 funds with very high and 27 funds with extremely high expense ratios. The number of funds in each of these two management fee and expense ratio standard deviation classes each represents 1.5% of total sample funds. Investors should consider these findings carefully, as should fund researchers, financial columnists and writers, investment advisers, financial planners and regulators. We also examine the association of management fees and expense ratios to descriptive performance measures by Morningstar category overall across each of the four standard deviation classes. These measures are the Sharpe ratio, Jensen alpha, Morningstar star ratings, and five-year annualized total returns.

Management fees have a mixed association with each of the performance measures. Each performance measure is higher in the extremely high management fee class ( 3σ) than in the above average management fee class (within 1σ). ANOVA tests only show significant differences for the Sharpe ratio and Jensen's alpha Morningstar categories overall across the four standard deviation classes. A potential implication of these results is that higher management fees may add value to active portfolio management and contribute to improved performance measures. These findings add fuel to the continuing debate over active versus passive portfolio management.

Expense ratios have the expected general negative associations with each of the performance measures. These findings are consistent with previous studies by Jensen (1968), Malkiel (1995), Gruber (1996), and Carhart (1997). Yet, ANOVA tests show significant differences only for the Morningstar star ratings and five-year annualized total returns by Morningstar category overall across the four standard deviation classes. Nonetheless, our results show that expense ratios maintain their negative associations with each of the performance measures despite the mixed associations of component management fees.

Keywords: actively managed, equity mutual funds, management fees, expense ratios, associations with performance

JEL Classification: G2, G23, G28