Are Cheaper Funds Really Better Bets?
No matter what we’re shopping for, there’s nearly always a positive relation between quality and price.
So why, on Wall Street of all places, would the best managers charge less?
Study after study concludes that on average, the lower an active fund’s fees, the higher its net performance. As a result, it’s now common for both individual and institutional investors to heavily weight expense ratios when selecting investments. In fact, the latest Morningstar Fund Fee Study revealed that in 2019, a whopping 93% of net new money into active strategies flowed into the least costly 10% of funds. Clearly, investors have become allergic to paying above-average fees.
In commoditized markets with high standardization and uniform quality, cheaper is indeed better. If there are two adjacent gas stations, for example, most people are happy to buy from whichever one is selling their preferred octane for a penny less.
Passive index funds are commodities too, so long as they offer enough liquidity and closely track the benchmark they’re supposed to replicate. In Economics 101, we learn that the price of a commodity is equal to its marginal cost. So, what does it cost Fidelity’s algorithm to create one new share of an index-tracking mutual fund? Apparently not much, since those fees have now dropped to zero.
Actively managed funds, by contrast, are anything but commodities. Their very purpose is to offer a differentiated return stream compared to their competitors, and there can be a huge dispersion between the top and bottom performers in a given category.
First-class tickets aren’t cheaper than flying coach, and tennis champions don’t get paid less than ball boys and girls — that just wouldn’t make sense. Therefore, the consistent finding of a backward cost-versus-performance relationship in active funds is highly counterintuitive. Why would we screen for bargain-bin funds in search of star managers?
In fact, highly skilled managers do charge more: They’re called hedge funds. If a top-fee-quartile mutual fund seems expensive, try paying a 5% management charge plus 44% performance fee for the honor of investing in Renaissance Technologies’ Medallion strategy.
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 favor low-cost funds. Here’s why:
Suppose that a given fund manager has no edge: In other words, their relative performance is just a function of fluctuating luck. Over time, their fund would be expected to mirror its benchmark on a gross basis. Because the manager doesn’t add any value, the more they charge, the worse their fund ranks versus peers: In the end, net performance simply equals the benchmark minus the manager’s fee.
Unfortunately, this phenomenon describes most active long-only funds. 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.
That’s where the backwards statistical relationship comes from. It’s not that the best managers give discounts; it’s that the market is swamped by a large number of strategies that fail to add value in excess of their costs. As a result, if we had to choose an active fund at random, without observing manager skill, our best bet would simply be to pick the cheapest one. That’s because we’d most likely end up with one of the many underperformers — in which case, the less we pay, the better.
Here’s where this reasoning falls flat. In order for an investor to rationally allocate money to an active fund in the first place, they need to believe that their due diligence process can accurately measure quality. If they have no way of discerning skill, taking a chance on ending up with an outperforming fund is a bet with long odds. Instead, they should simply buy a passive index, because even the cheapest unskilled manager isn’t worth paying for when benchmark exposure comes practically for free.
If the investor does have a way of evaluating quality, then expense ratios shouldn’t matter much at all. Rather, all they care about is a fund’s ability to deliver net outperformance, after its fees. For example, if Renaissance allowed new assets into its Medallion fund, investors would line up to buy in. Fees only have meaning in comparison to returns.
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. This makes it unlikely that the best managers are clustered in the lowest-cost funds. As a result, screening based on fees is a particularly bad idea, and could end up eliminating the strongest funds from the outset.
Incidentally, if fund investors’ myopic focus on fees continues, high-ability portfolio managers will exit the market over time, and their employers will replace them with lower-cost stand-ins. The extreme case is a market failure where only the “lemons” remain. Should that occur, active funds won’t be worth buying at any price.
The takeaway? Investors should be agnostic to absolute fees, and instead rank investment options on their value added net of costs. If they aren’t equipped to do that accurately, they’ll be better served by avoiding the risks and expense of active management in favor of low-cost indexes.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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“In fact, highly skilled managers do charge more: They’re called hedge funds.”
Most hedge funds also fail to deliver value.
You’re absolutely right, although based on my analysis the proportion of managers adding value in that space is higher than in mutual funds. We also observe that the hedge funds with the strongest long-term track records tend to charge more, not less, than average.
Survivorship bias is a bigger problem for hedge funds. How does you analysis account for this?
My data includes shuttered hedge funds, but you’re right that poor performance is systematically underreported because managers either cease reporting to databases, or never report failed start-up funds.
Depending on your assumption about the magnitude of survivorship bias, you might conclude that hedge funds have just as poor of an overall track record as mutual funds. While my view isn’t that extreme, I do find that the majority of hedge funds don’t demonstrate alpha when appropriately benchmarked.
Does generating value for investors necessarily mean generating alpha?
Or does it mean meeting the objectives of the fund (eg low volat, income generation, impact, etc.).
If the latter, what matters most is the quality of the advice provided to the investor depending on his/her circumstances.
My 80+ mother would probably be ill-advised to “buy the market” or go after alpha generation.
Low volatility and income strategies can be implemented passively. To the extent a lower-cost passive alternative is available, an active manager does need to generate alpha to add value over the passive option.
Active versus passive is an implementation question, distinct from asset allocation decisions and general financial advice. Certainly, quality guidance in those areas can be valuable.
Are you comparing those hedge funds (best and long-term) against only other funds that have been around as long? Are funds with shorter track records included as well?
I use a Bayesian modeling approach for performance analysis, which permits direct comparison of strategies with different history lengths.
However my comment was really referencing the fact that the hedge funds able to charge atypically high fees (e.g. incentive fees of 30%+) tend to be those that have a long run of stellar returns, which the market reads as a sustainable edge — a.k.a. skill. It’s unusual to see newer funds commanding a premium out of the gate, even with a strong initial track record.
Successful managers may also increase fees as a way of growing revenue while constraining AUM growth, since higher assets under management tend to make it more difficult to generate alpha.
I believe you have made a cognitive error in your article. Management fees are not flat sums like “first class ticket prices” or “tennis pro vs ball boys salaries”…
They are PERCENTAGES!
An active manager who charges 10 bps less than peers, but has 10x the AUM is certainly not earning less than the more expensive peer group.
This article is good fodder for lazy industry veterans who want confirmation bias (Am I the bad guy? No it’s definity the market thats wrong!)
Maybe new innovative fee structure ideas should be written about instead of this status quo commentary?
Flat fee, fee for service, etc all come to mind as potential ideas outside the lazy “performance fee” of managers who often take risk to rake in a windfall profit.
Our industry loves to think in terms of how they can pull more capital from investors’ pockets.
Counter to that, what’s the best way to benefit the investor?
“Incidentally, if fund investors’ myopic focus on fees continues, high-ability portfolio managers will exit the market over time, and their employers will replace them with lower-cost stand-ins.”
If you read the S&P SPIVA data, it seems the “lower-cost stand-ins” were always there.
Markets are cyclical and there is a lack of persistence from top managers. I dont know how someone can confidently “believe that their due diligence process can accurately measure quality” and skills. One of the biggest behavioural bias in our industry is to confuse better investment strategy (more quality) with higher price. This heuristic come from the fact that it works well in many of the products we buy, but not when we are buying our investment funds. After all, the future is uncertain and past performance doesn’t guarantee future results. Academic studies would suggest to control what you can and its cost.