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July 19, 2017
401(k) Expenses Lower in 2016 Due to Demand for Passive Funds, Price Wars

By Jane Meacham, Contributing Editor

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Remaining informed and aware of investing trends is one of the many duties that come with being an employer plan sponsor or serving on a plan’s investment committee. As average fund fees continue their slide from investors seeking lower-cost funds and price wars among some providers, it’s useful to understand what’s behind this trend. At worst, a failure to align your plan’s investment options with the rise of passive funds and dramatically reduced fees also could expose the plan to participant litigation.

401k cash envelopeMorningstar Manager Research study of U.S. open-end mutual funds and exchange-traded funds (ETFs) published in late May found that, on average, investors paid lower fund expenses in 2016 than ever before. The independent, fundamental analysis of managed investment strategies said the decline stems from strong investor demand for cheaper funds, principally passively managed ones and institutional share classes that carry lower fees.

“This is a positive trend, as mutual fund costs have dollar-for-dollar impact on the returns investors ultimately realize,” wrote Morningstar Manager Research Senior Analyst Patricia Oey in the report.

Migration to Institutional-Class Shares

Morningstar said the share-class migration, led by 401(k) plans gravitating toward cheaper shares, was partly the result of a change in the financial advisory industry toward a fee-based model and away from commissions. Fee-based advisers are more inclined to use lower-cost vehicles such as passive funds and ETFs. The shift by 401(k) plans’ investors to less-costly share classes contributed to increased availability and usage of institutional-class shares among all investors, the research report said.

The asset-weighted average expense ratio across funds (excluding money market funds and funds of funds) was 0.57% in 2016, dropping from 0.61% in the previous year and 0.65% in 2013.

However, the study found that the simple average expense ratio of the largest 2,000 funds in 2013, which accounted for 85% of assets in mutual funds and ETFs, was 0.72% in 2016, unchanged from the prior 2 years—which means the decline in average mutual fund fees stems largely from investors’ migration to lower-cost funds, not cuts to fees in the most widely held funds.

Morningstar explained in the report on its 2016 fee study that it used the asset-weighted average expense ratio rather than a simple, or equal-weighted average, expense ratio because the firm believes the former is “a better measure of the average cost borne by investors than a simple average, which can be skewed by a few outliers, such as high-cost funds that have low asset levels.”

This migration has been driven by individual investors but is gaining traction among institutional funds such as pension and 401(k) retirement plans, which can have a greater impact on the investment marketplace.

Passive funds’ asset-weighted average expense ratio was 0.17% in 2016, compared with 0.75% for actively managed funds. “This wide fee gap, coupled with record flows of $429 billion into passive funds and $326 billion out of active funds in 2016, contributed to falling industrywide asset-weighted average expense ratios,” the Morningstar study said.

Passive funds’ average fee slid a cumulative 19% during the past 3 years, the research found, significantly more than the 6% decline that active funds posted during the same period. Price cuts by Vanguard and BlackRock/iShares, major money managers for employer-sponsored plans, in some of their index funds also helped drive lower passive funds’ asset-weighted average fees, Morningstar said.

U.S. equity funds, often the backbone of defined contribution (DC) retirement plan investment menus, have recorded the largest migration to passive funds from active funds, with the former drawing in $458 billion of inflows and the latter experiencing outflows of $524 billion over the past 3 years. During that time span, U.S. equity funds’ fees fell a cumulative 17% to 0.50%, the largest decline of any asset class reviewed by Morningstar.

Average fees paid by investors fell in six of the seven major asset classes from 2013 to 2016, the report stated.

Most Expensive Asset Class

Load shares cost investors the most among asset classes, with 1.01% in annual fees, a portion of which typically pays for distribution and marketing costs.

“Vanguard has had a significant impact on the industry’s asset-weighted average expense ratio and the recent pace of fee declines, as the company’s low-cost passive funds continue to attract large inflows,” the Morningstar report said. During the past 3 years, Morningstar said Vanguard’s asset-weighted average fee dropped a cumulative 21%, the biggest fall among the largest 10 fund families, followed closely by BlackRock/iShares.

Some other major fund providers have trimmed fees on their largest funds, the report said, either because of asset growth or possibly to be more competitive.

Jane Meacham is the editor of BLR's retirement plan compliance publications. She has nearly 30 years' experience as a writer/editor of financial services news.

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