Morningstar Magazine - October/November 2017 - 27

Dispatches

and capital-allocation model that Praxair offers
to exploit its huge, underperforming asset
base. The proposed combination offers an elegant
solution, and the timing seems propitious for
sidestepping major management clashes and
governance controversies.
David Silver, CFA, CPA, is a senior analyst with Morningstar
Research Services.

Some High-Cost
Funds Are Looking
Even Pricier
Earlier this year, Morningstar published a fee
study of U.S. open-end mutual funds and
exchange-traded funds. (See "Great Migration"
in the August/September issue of Morningstar.)
Two conclusions should jump out at fund
company executives.
First, the weighted-average fee that investors pay
continues to fall, from 0.65% in 2013 to 0.57%
in 2016. Second, investors continue to pull money
from expensive funds (typically actively managed)
and plow it into the cheapest funds, which are
often passively managed. But even the weightedaverage fee for active U.S. equity funds dropped to
0.77% from 0.83% during the same stretch.
So, investors are clearly more cost-conscious lately
as they target cheaper funds, pushing
weighted-average fees lower. It would seem that
more-expensive funds would need to cut their
expense ratios just to maintain their relative cost
positions. Yet it doesn't appear that this is
happening-at least not to a sufficient degree.
Morningstar analysts rate more than 1,000
open-end mutual funds. During the past
three years going back to 2014, there have been
217 changes to the Price Pillar rating-
one of the five pillars that go into the overall
Morningstar Analyst Rating-among the
funds that Morningstar covers. Of these changes,
178 of them were downgrades (to Neutral
from Positive or to Negative from Neutral) and

only 39 were upgrades. That's a ratio of 4.6
downgrades for every one upgrade. Clearly, many
funds are becoming less cost-competitive as
weighted-average expenses drop.
There are typically two reasons for such
downgrades. As Warren Buffett might put it, think
of them as errors of omission and errors of
commission. First, let's look at errors of omission:
in this case, not cutting expense ratios proactively
to maintain relative cost competitiveness.
That is, even though a fund's expense ratio may
not have changed, its relative standing among its
peers has likely deteriorated.
Take American Century Heritage TWHIX. As with
the investor share class of many American
Century equity funds, its expense ratio has long
held firm at 1% of assets. In 2013, that was 11 basis
points below the mid-cap no-load peer median.
But since then, the median peer expense ratio has
fallen 7 basis points to 1.04%. While American
Century Heritage's 1% expense ratio is still 4 basis
points below the median, it now falls in
Morningstar's average fee range of 0.99% -1.12%
for its peer group. Thus, its Price Pillar rating was
cut to Neutral from Positive.
So, just keeping a fund's expense ratio stable
is no longer sufficient for many funds. Given recent
trends, it would seem much worse to actually
increase a fund's expense ratio and raise its
price-that is, to make an error of commission.
But it happens.
Many actively managed funds are getting squeezed
at both ends: They're confronted by increasing
competition from low-cost funds, whether active or
passive, while they're also contending with
outflows as their clients flee to cheaper options.
So, just as they're facing stiff price competition,
many advisors are forced to spread their
costs-almost all of which are fixed in the short
run-across a smaller asset base.
Therefore, if overall assets fall and operating costs
remain the same, all else equal, a fund's
expense ratio will increase to cover those costs.
For example, AMG Managers Montag &
Caldwell Growth MCGFX recently had its Price
rating downgraded to Negative from Neutral.

This fund got caught in the trap. An estimated
$4.65 billion poured out of the fund during
the past five years, and total assets dropped to
$952 million, mostly stemming from poor
relative results since 2009. The fund's expense
ratio increased to 1.12% from 1.04% as it bled
assets. Meanwhile, the median expense ratio for
its large-cap no-load peer group fell from
0.97% in 2013 to 0.9%.
Executives at firms such as Montag & Caldwell
may see such expense-ratio increases
as what's needed to cover their costs. But they
should keep in mind that from an investor's
perspective, it simply looks like a price increase,
coming at a less than ideal time. Former
hedge fund manager Andy Kessler pointed out
the dangers of raising prices under such
circumstances in a recent Wall Street Journal
commentary, "The High Cost of Raising Prices."
Applying that thinking here, raising prices will only
make it likelier that-all other things equal-
more money will be pulled from such funds.
There are no easy answers for actively managed
funds wishing to remain competitive. Certainly,
mediocre or poor performance is often a
big reason for the exodus from active equity funds
in particular. But more active firms need to take a
much harder look at the fees they charge and
become far more proactive in cutting them. While
the behavior of financial markets isn't under
their control, what they charge clients always is.
Kevin McDevitt, CFA, is a senior analyst with Morningstar
Research Services.

Monthly AUM Is a
Positive Trend
We're pleased to see the number of U.S.-based
asset managers we cover that provide preliminary
monthly data on assets under management
increase from five to seven. Since the start of the
third quarter, T. Rowe Price TROW and
Waddell & Reed Financial WDR have joined
Invesco IVZ, Franklin Resources BEN, Legg Mason
LM, AllianceBernstein AB, and Cohen &

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Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2017

Contents
Morningstar Magazine - October/November 2017 - Cover1
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Morningstar Magazine - October/November 2017 - 1
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Morningstar Magazine - October/November 2017 - Contents
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