Efficiency of the Mutual Fund Industry: an Examination of U.S. Domestic Equity Funds: 1995-2004

Investors have the ability to choose between two different management styles in the mutual fund industry. These two management styles differ in both the investment strategy type the fund executes and management costs, which are charged to the funds’ investors. First, investors may invest their funds in index funds, which employ a passive investment strategy. Here, investors expect to earn a rate of return equivalent to the market index—minus a small management fee—which the fund seeks to track. Alternatively, investors may choose active fund management. The returns of these mutual funds rely on stock selection ability of portfolio managers. Active portfolio managers perform securities research and obtain information in an attempt to distinguish between undervalued and overvalued securities—allowing them to outperform the market. To compensate for the cost of this research, these funds generally charge a higher management fee which is paid by individual mutual fund investors. In 2004, the average actively managed fund expense ratio was approximately 140 basis points, while the majority of index funds charge fees ranging from 10 basis points to 50 basis points. A expense ratio of 140 basis points would mean that $140 of every $10,000 invested by an individual in a fund will go to the portfolio manager in order to compensate them for their research and management. Some funds carry further expenses in the form of load charges. They take a percentage of an investors initial investment as a sales commission, as these funds are distributed directly by the fund management company. Much debate within the investment community has revolved around the question of whether the fees charged by actively managed mutual funds are justified with higher returns. [excerpt]