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Fat Fund Report

How Much Does Cost Matter?

How much will it cost you to “pay up” for a mutual fund? A lot. While there is no guarantee that every high cost fund will perform more poorly than every low-cost fund, high cost funds, on average, provide lower returns than low-cost funds.

Obvious, you say? Logical, you say?

Well, yes.

But what is obvious and logical doesn’t prevent high pressure marketing from the fund companies that reward themselves first, and most. And, sadly, there are literally thousands of funds that are expensive-- unnecessarily expensive. You can see the performance difference by considering this examination I did of the 10 percent most expensive funds in major categories with the 10 percent least expensive funds in major categories.

Over the three years ending June 30th the performance gap for the 11 types of equities funds examined averaged 1.24 percent, annualized. The biggest performance gap, 2.29 percent, annualized, was in the funds Morningstar categorizes as “World Stock” funds— funds that can invest in equities anywhere in the world, including the domestic market. The smallest performance gap was in domestic mid-cap growth funds, only 0.52 percent.

One surprising result was that the average high cost mid-cap value fund actually returned more than the average low cost mid-cap value fund, leading by 0.69 percent. Does this atypical result mean anything? I don’t think so. It simply demonstrates the probabilistic nature of mutual fund results. While high-cost funds will probably trail low-cost funds in performance, it isn’t inevitable. It’s just probable.

These figures will change from quarter to quarter, depending on how the markets have performed over the trailing 3 year period.

The average performance gap in the two categories of hybrid funds examined was 0.82 percent.

The most surprising result was found among fixed income funds. There, I examined 4 categories of fixed income funds and found an average performance gap of a whopping 1.78 percent. That’s a pretty clear indication that costs trump manager performance in the fixed income arena.

So what can we do to improve investment performance with little or no knowledge of investments?

Answer: We can be concerned with expenses. If someone who calls himself an “investment adviser” recommends a portfolio in which every fund has expenses in the top 10 percent or top 25 percent, you can be pretty sure that the advisor is working in an environment where the only choice he has is high-cost fees.

It isn’t inevitable, however, that you’ll face high-cost fees from an investment adviser whose primary source of income is sales commissions. As I have pointed out many times in columns, it is possible to find a commissioned salesman who will put you in low cost, but broker distributed, funds such as the American Funds group. While the front-end load on these funds can be as high as 5.5 percent, their typical ongoing expenses run about 0.70 percent.

As a consequence, it will take about 4 1/4 years to “catch-up” on the total expenses of fund choices that cost 2.00 percent a year but have no front-end commission. That 4 1/4 year figure, however, is the maximum “catch-up” period because the American Funds group, like most fund firms, reduces the commission as the amount invested rises. Invest $1 million, for instance, and there is no commission.
So if your financial adviser only offers high cost funds, you know that serving your interests is probably not his primary concern.

Measuring the Performance Gap