This section describes the set of mutual funds
used for the analyses that follow. It also provides information
on key characteristics of such funds. Expenses, turnover ratios
and total assets for some funds as of December 1993 were taken
from the *Principia Plus* CD-ROM issued in January 1994.
All other data were obtained from Morningstar's *Principia
Plus* CD-ROM issued in January 1997 which included data on
fund returns and characteristics through the end of December
1996.

The following table shows the number of funds as of December 1996 for which Morningstar data were available for the last 1,3,5 and 10 years:

Number of funds, December 1996

Asset Class1 Year3 Years5 Years10 YearsDomestic Equity2,959 1,826 1,058 598 International Equity835 383 185 60 Taxable Bond1,670 1,104 597 242 Municipal Bond1,739 1,129 580 257 Total7,2034,4422,4301,157

Our analyses focus on funds with at least three years of data. The table below shows the number of such funds in each asset class, their total assets at the end of 1996, and the average amount of assets per fund.

Number of funds, assets ($ million), and assets/fund ($ million), December 1996

FundsAssetsAssets/FundDomestic Equity1,826 1,340,582 734 International Equity383 230,570 602 Taxable Bond1,104 339,307 307 Municipal Bond1,129 243,966 216 Total4,4422,154,425485

As the previous table shows, domestic equity funds have well
over half the assets. Moreover, the bulk of those assets are held
by funds which Morningstar assigns to its nine *diversified
equity* categories. At the end of 1996, there were 1,306 such
funds. Of these, 18 were not assigned to categories and were
excluded from this study since our goal is to compare all the
performance measures including those utilizing category
information. In addition, two of the funds had extremely high
expense ratios (greater than 10%). They were also excluded in
order to avoid outliers that could dominate both performance
statistics and some of the regression analyses.

The tables below show, respectively, the number of funds, total assets at the end of 1996, and average assets per fund for the1,286 remaining funds:

Number of funds, December 1996

ValueBlendGrowthTotalLarge159 370 107 636Medium79 123 170 372Small94 74 110 278Total3325673871,286

Assets ($ million), December 1996

ValueBlendGrowthTotalLarge185,093 349,939 105,759 640,790Medium44,989 149,009 136,966 330,963Small28,207 19,171 49,557 96,934Total258,287518,118292,2821,068,687

Assets/Fund ($ million), December 1996

ValueBlendGrowthTotalLarge1,164 946 988 1,008Medium570 1,212 806 890Small300 259 451 349Total778914755831

As can be seen, blend funds held more assets than either value or growth funds. Large-capitalization funds held considerably more assets than medium-capitalization funds, which in turn held considerably more assets than small-capitalization funds. Finally, small-capitalization funds were themselves small, holding fewer assets per fund on average than their medium and large-capitalization counterparts.

These 1,286 diversified equity funds make up our main ("3-year") sample. At the end of 1996, they held approximately half the assets held by mutual funds with at least three years of history, and thus constituted a major portion of the industry.

For some analyses we utilize the subset of the funds in the 3-year sample for which returns are available beginning with December 1990 or earlier and for which expense ratios, turnover percentages and total assets as of the end of 1993 were included on the Morningstar CDROM produced at the time. Of the 1,286 funds in the 3-year sample, 541 fulfilled these conditions. The primary reason that this is a much smaller sample is the rapid increase in the number of funds in the 1990's. Many of the funds in existence in 1994 were formed during the prior 3 years. However, some of the funds in existence at the end of 1993 undoubtedly subsequently disappeared through merger or liquidation or changed objective sufficiently to be renamed and/or reclassified by Morningstar. For the latter reasons, the 6-year sample is subject to survivor biases of unkown magnitude and results of our "out of sample" tests should be interepreted with considerable caution.

Two characteristics that affect the net performance of a fund
are (1) the costs of management and administration, summarized in
its *expense ratio* and (2) the magnitude of its security
purchases and sales, summarized in its *turnover ratio*.

Morningstar's expense ratio is:

"A figure taken from the fund's prospectus that represents the percentage of fund assets paid for operating expenses and management fees, including 12b-1 fees, administrative fees, and all other asset-based costs incurred by the fund, except brokerage costs.... Sales charges are not included.."

^{1}

The following diagrams show the cumulative distribution of expense ratios. For convenience, only ratios from 0 to 2% are shown, although the entire range is used for calculations and the determination of the curves.

In the first case, each fund is given equal weight. The
vertical axis thus shows the proportion of *funds* with
expense ratios smaller than the value shown at the corresponding
point on the horizontal axis. For example, to see the median
expense ratio, select the 0.5 point on the vertical axis. Move
right to the left-most point on of the shaded distribution, then
down to the horizontal axis. The value on the latter is 1.19.
Thus, 50% (0.50) of the funds had expense ratios smaller than
1.19 (and 50% had ratios greater than 1.19). Continuing in this
manner, the graph shows that 20% (0.20 on the vertical axis) of
the funds had expense ratios smaller than approximately 0.90 (on
the horizontal axis), and 80% thus had ratios greater than 0.90.

Cumulative distribution of expense ratios: equally-weighted

While it is interesting to determine the expense ratio for the average fund, for many purposes it is more relevant to determine the expense ratio for the average dollar invested in a set of mutual funds. To do so, one must weight larger funds more heavily than smaller funds. The diagram below does this. As can be seen, the median expense ratio is considerably smaller (well less than 1.00).

Cumulative distribution of expense ratios: dollar-weighted

The table below provides summary information for both cases. Due to the presence of a few funds with very high expense ratios (not shown on the graphs), the mean is higher than the median in each case. Moreover, the values are considerably lower when dollar weights are used instead of equal weights. Perhaps the most relevant number in the table is the one in the lower left. Investors in this group of mutual funds collectively paid expenses equal to 0.952%, or 95.2 cents per year on every $100 invested. It is reassuring that the dollar-weighted figures are considerably smaller than the frequently quoted and less relevant equal-weighted numbers (such as the 1.305% in this sample). Note, however, that the inclusion of low-expense index funds in the sample gives lower values than would be obtained if only actively-managed funds were analyzed.

Expense ratios

MeanMedianEqual-Weighted1.305 1.190 Dollar-Weighted0.952 0.920

Morningstar obtains the turnover ratio from fund shareholder reports. To compute it,

"A fund divides the lesser of purchases or sales (expressed in dollars and excluding all securities with maturities of less than one year) by the fund's average monthly assets."

^{2}

The diagrams and table below provide information on the turnover ratios of the funds in our sample. Only ratios from 0 to 200 percent are shown, although all values are used for the calculations and the determination of the curves.

Cumulative distribution of turnover ratios: equal-weighted

Cumulative distribution of turnover ratios: dollar-weighted

Turnover ratios

MeanMedianEqual-Weighted80.4 64.0 Dollar-Weighted73.8 53.0

Here, too, the dollar-weighted mean is the most relevant. Approximately 73.8% of the dollars invested in this set of diversified equity funds were turned over each year. This clearly added to fund and investor's costs. Whether or not commensurate gains in value were obtained remains to be seen.

The difference between the dollar-weighted and equal-weighted expense ratios shows that on average, larger funds have lower expense ratios due, no doubt, to their economies of scale and ability to spread fixed costs over more assets. The diagram below shows that this holds quite regularly. Each bar shows the (equally-weighted) average expense ratio of the funds in each of ten deciles (129 fundsin each of the first nine deciles and 125 in the tenth) based on assets under management. Thus the average fund in the lowest size decile charged 1.89% per year in expenses, while the average fund in the largest size decile charged 0.96%.

Average expense ratios for ten deciles based on asset value

Size does not appear to be closely related to turnover as the diagram below indicates.

Average turnover ratios for ten deciles based on asset value

While size is not related to turnover, expense ratio is, as the diagram below shows. The roughly ten percent of funds with the lowest expense ratios averaged a turnover of slightly over 40%, while those with the highest expense ratios averaged more than 100%. Since the costs of trading (explicit and implicit) are generally excluded when computing expense ratios, this suggests that funds with high stated expenses tend to also have high unstated expenses. Since both types of expenses reduce returns, managers of such funds would have to increase gross returns by larger amounts than their low-expense counterparts in order to even match the latter's net returns. Analyses of net performance are required to see if they succeed.

Average turnover ratios for ten deciles based on expense ratios

*1.** Advanced Analytics for
Morningstar Principia Plu*s

*2.** Morningstar Mutual Funds
User's Guide*

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