Investors who insist on minimizing expenses might be making a painful tradeoff
Given the pressure for investors to build up a strong-enough nest egg for retirement, no one deserves blame for wanting the most bang for their investment buck. In the field of fund investment, the evidence suggests they should be looking for the lowest-cost offerings – but that’s oversimplifying things.
“Study after study concludes that on average, the lower an active fund’s fees, the higher its net performance,” said Jordan N. Boslego, CFA and co-founder of Empirically, in a blog post published by the CFA Institute. “As a result, it’s now common for both individual and institutional investors to heavily weight expense ratios when selecting investments.”
Boslego cited the latest Morningstar Fund Fee Study, which found that 93% of net new money flowing into active strategies in 2019 went into the cheapest 10% of funds. He argued that while this might be sensible for passive, index-tracking funds, it’s not a sustainable situation for actively managed funds, whose purpose is to seek a differentiated return stream from their competitors.
“While an inverse relationship between expense ratio and performance does indeed exist on average, it’s a fallacy to use that fact as a basis to favour low-cost funds,” he said.
Most active long-only funds, he explained, are offered by managers whose relative performance is just a function of fluctuating luck. That means over time, their performance is expected to be no better than that of their respective benchmarks on a gross basis; on a net basis, it’s worse because of their higher fees.
“Depending on the sample and methodology used, research consistently shows that from 60% to more than 90% of managers don’t exhibit any persistent advantage over a passive benchmark,” he said. “That’s where the backwards statistical relationship comes from. … [T]he market is swamped by a large number of strategies that fail to add value in excess of their costs.”
Given that situation, an investor choosing an active fund at random would be overwhelmingly better off choosing one that’s low-fee, since the odds are that they’ll pick one of the many underperformers. But investors who rationally allocate to an active fund, he argued, would be using a due diligence process they believe can accurately measure quality; if they indeed have a method to discern top-notch funds, then expense ratios shouldn’t matter much, and net outperformance should be the target.
“Because skilled managers deliver value for their investors, it’s natural that they also generally capture more value than their unskilled peers in the form of fees,” Boslego said, arguing that the best managers are most likely not clustered in the lowest-cost segment of the fund universe. “As a result, screening based on fees is a particularly bad idea, and could end up eliminating the strongest funds from the outset.”