Academic journal article Financial Services Review

Performance and Characteristics of Actively Managed Retail Equity Mutual Funds with Diverse Expense Ratios

Academic journal article Financial Services Review

Performance and Characteristics of Actively Managed Retail Equity Mutual Funds with Diverse Expense Ratios

Article excerpt


We investigate the relation between the performance and characteristics of 1,779 domestic, actively managed retail equity mutual funds with diverse expense ratios. We show that using expense ratio standard deviation classes is an effective method for characterizing fund expenses for investors. Using various performance measures including Russell-index-adjusted returns, the results indicate that superior performance, on average, occurs among large funds with low expense ratios, low trading activity, and no or low front-end loads. Performance is invariant with respect to whether funds have 12b-1 fees.

© 2008 Academy of Financial Services. All rights reserved.

Jel classifications: G23; G11

Keywords: Mutual funds; Expense ratios; Performance characteristics

1. Introduction

Actively managed retail equity mutual funds in the United States have trillions of dollars in assets and collect tens of billions in management fees. These funds also attract tens of millions of investors because they offer a convenient method of investing, diversification benefits, and liquidity. Most studies find that the universe of mutual funds does not outperform its benchmarks after expenses and only a small percentage of mutual fund managers have market timing ability or selectivity expertise. Nonetheless, retail investors continue to pour money into actively managed funds in pursuit of superior performance. Baks, Metrick and Wachter (2001) caution that the case against investing in actively managed funds cannot rest solely on the available statistical evidence.

In this study, we focus on domestic equity mutual funds designed for retail investors. Our purpose is threefold: (1) to analyze the disparity of expense ratios of actively managed retail equity funds, (2) to examine fund performance and fund characteristics partitioned by expense ratio class, and (3) to identity fund attributes that contribute significantly to fund performance. We make a strong effort to establish robust results by using a wide range of performance measures and a large cross-section of funds.

Our findings contribute to the financial services literature in several ways. First, we update and expand previous mutual fund research and provide recent evidence on the relation between fund performance and characteristics. An important issue facing investors is whether they can use mutual fund characteristics such as expense ratios and other attributes to distinguish superior from inferior performance. Second, unlike previous studies, we use expense ratio standard deviation classes to examine mutual fund performance and other fund attributes.

2. Data and method

2.1. Measuring expense ratios

We use expense ratios as a percentage to measure mutual fund costs and standard deviations to characterize expense ratio diversity.1 The expense ratio is total expenses divided by fund average net assets.2 This ratio consists of management fees, Rule 12b-l fees, and "other" expenses but excludes sales loads and fees directly charged to shareholder accounts and security transaction costs (brokerage fees, bid-ask spreads, and market impact costs) that reduce portfolio returns.3

2.2. Classifying funds by standard deviation

We use a simple, probabilistic method to identify mutual funds with varying degrees of expense ratios based on their standard deviation. This approach is conceptually similar to sorting funds into deciles or quintiles by expenses, which Malkiel (1995) and Carhart (1997) have already done. By contrast, our method classifies each fund based solely on the magnitude of its expenses relative to its peer-group average rather than based on the fund's position after a simple sorting procedure. We apply the distribution-free Chebyshev's inequality because there is no certainty that a normal distribution applies for the financial variables under consideration. The likelihood of observing expense ratios two or three standard deviations above the mean is relatively small, even if the variable is not normally distributed. …

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