S&P 500 Index Mutual Funds
By John Haslem, Kent Baker and David Smith | February 28, 2007

The commodity-like nature of index mutual fund portfolios suggests that price competition should be more evident than with actively managed funds. After all, fund managers operate index funds not to beat their benchmarks or actively managed funds, but to mimic benchmark portfolios and performance, less expenses. Therefore, fund expenses should be singularly important in explaining and predicting differences in index fund performance. Haslem (2003) addresses the broader issues of fund expenses.

With vigorous price competition, asset size and 12b-1 fees should account for most of the differences in expenses for index mutual funds with the same benchmarks. However, as discussed by Ptak (2004), the realities are quite different:

Index funds are a logical starting point . . . given their commodity-like nature (which should, in theory at least, breed fierce price competition). Index funds that track the same benchmark, such as the S&P 500 index, are virtually identical in terms of holdings. They also cost very little to operate since management merely entails purchasing the securities in the same proportion as the bogey and periodically rebalancing in response to asset flows or reconstitution of the benchmark. In other words, differentiation is nonexistent, barriers to entry are modest, and, it would seem, cost is king.

However, you wouldn't know it judging from the diversity of fees levied on index funds tracking the same benchmark.

Elton, Gruber and Busse (2004) find that the reality underlying the market for S&P 500 index mutual funds is explained by the presence of uninformed investors and fund distributors with economic incentives to sell inferior funds. Thus, we should not be surprised (but perhaps dismayed) by the presence of large differences in management fees and expense ratios.

As to the implications of findings of large differences in management fees and expense ratios, Ptak (2004) concludes that:

The stakes in the cost battle are enormous. While low costs greatly improve a fund's chance of outperforming peers while also moderating risk, the same high costs that have hampered fund performance have been an absolute boon to the fund industry.

The U.S. Securities and Exchange Commission (2000) has also voiced serious concern about the size of mutual fund expenses. The SEC's expressed interest is not from the standpoint of regulating fund expenses, which optimally should be market determined, but from its role in regulating fund directors, who approve fund expenses.

Mission

This study's mission is to provide investors, researchers and regulators with: (1) an improved understanding of the dispersion of management fees and expense ratios among the mutual funds that track the S&P 500 index; and, (2) the association of fund performance measures and characteristics to classes of both dispersed management fees and expense ratios. These measures and characteristics include the Sharpe ratio, Jensen's alpha, Morningstar Star Rating, annualized total return (3-yr.), portfolio turnover, 12b-1 fees and average net assets.

Sample And Method

The initial sample of 202 investor- and institutional-class S&P 500 index mutual funds is from Morningstar (2005), and includes single share class funds and each class of multiple share class funds. Thus, each share class is a "fund," and the number of unique portfolios is fewer than the number of "funds."

S&P 500 index mutual funds represent 41 percent of the total of 498 index funds. In addition, there are 83 distinct S&P 500 portfolios, which represent 35 percent of the total of 239 distinct portfolios. However, due to incomplete data, it was necessary to reduce the sample to 171.

The method in Haslem, Smith and Baker (2005) is used to identify the S&P 500 index mutual funds with (1) above (below) average, and (2) varying degrees of statistically high (low) management fees and expense ratios. Following this analysis, the selected performance and related characteristics are related to each of the statistical classes of fund costs.

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