U.S. mutual fund business is a multi-trillion industry with total net assets of US dollars 11,120.73 billion as of 2009. The share of equity funds in the industry increased from 323 funds in 1970 to 4,659 funds in 2009 with total net assets of US dollars 4,957.58 billion. The mutual fund industry manages about 20 percent of U.S. household financial assets with approximately 90 million U.S. investors currently owning mutual fund shares.
The investors in mutual funds are interested in their performance, taking into consideration their expense ratio and risk. Risk is composed of a systematic part, that cannot be eliminated, or diversified away, and an unsystematic part, or specific risk, which can be eliminated and diversified away. Investors are rewarded only for the systematic component of risk. This distinction between systematic and unsystematic risk is at the foundation of the Capital Asset Pricing Model (CAPM) which is used in this paper
The return of a mutual fund is calculated by taking the change in the fund's net asset value, which is the market value of securities the fund holds, assuming the reinvestment of all income and capital again distributions, and dividing it by the original net asset value.
The expense ratio is the fund’s operating expense divided by the average dollar value of its assets under management. U.S. domestic funds have an average expense ratio of 1.3% which is slightly higher than the ratio reported in other countries (Ferreira et al., 2009). During the stock market downturn that lasted from early 2000 to early 2003 the average expense ratio of stock funds temporarily increased several basis points. This largely reflected the sharp decline in the assets of stock funds during that downturn because certain fund costs (transfer agency fees, accounting and audit fees, director’s fees, and various other fees) tend to be relatively fixed in dollar terms.
As the assets of stock funds fell, those relatively fixed dollar fees contributed proportionately more to the expense ratios of stock funds. When the stock market began to recover in early 2003, the assets of stock funds rebounded, and stock fund expense ratios resumed a downward trend. From 2003 to 2008, the average expense ratio of stock funds fell each year. During the stock market downturn that began in October 2007 the assets of stock funds again declined markedly and, consequently, the expense ratios increased.
This rise in fund expense ratios, as during the market downturn earlier in the decade, seems likely to be temporary. In 2009, equity fund investors on average paid 99 basis points (0.99%) in fees and expenses. The average in this paper’s sample is 124 basis points or 1.24%. Of course the expense ratio varies from fund to fund.
Two important groups of studies on mutual fund performance are pertinent. The first group is related to the efficient market hypothesis (EMH) and the random walk behavior of stock prices (Fama, 1965, 1970, 1991). According to the EMH stock prices incorporate all public information, and stock returns are unpredictable. Stock prices are equally likely to go up and to go down, and nobody can earn abnormal profits by trading, stock picking, or market timing. Hence active trading is wasteful. A buy and-hold policy cannot be beaten.
