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The Mutual Fund Landscape - Part Three

The impact of costs

If competition drives prices to fair value, one might wonder why underperformance is so common. A major factor is mutual fund costs. Costs reduce an investor’s net return and represent a hurdle for a fund. To outperform, a fund must add enough value to exceed its costs.

All mutual funds incur costs. Some costs, such as expense ratios, are easily observed,
while others, including trading costs, are more difficult to measure. The question is not whether investors must bear some costs, but whether the costs are reasonable and indicative of the value added by a fund manager’s decisions. 

The research shows that many mutual funds are expensive to own and do not offer higher value for the higher costs incurred. Let’s consider how one type of explicit cost—expense ratios—can impact fund performance.

In Exhibits 4.1 and 4.2 (below), equity and fixed income funds in existence at the beginning of the five-, 10-, and 15-year periods are ranked by quartiles based on their average expense ratio. The graph shows the percentage of winners (outperformers) and losers (underperformers) for each quartile across periods. 

 The sample includes funds at the beginning of the five-, 10-, and 15-year periods ending December 31, 2014. Funds are ranked by quartiles based on average expense ratio over the sample period, and performance is compared to their respective benchmarks. The chart shows the proportion of winner and loser funds within each expense ratio quartile. Past performance is no guarantee of future results. See Data appendix for more information. US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago.

The sample includes funds at the beginning of the five-, 10-, and 15-year periods ending December 31, 2014. Funds are ranked by quartiles based on average expense ratio over the sample period, and performance is compared to their respective benchmarks. The chart shows the proportion of winner and loser funds within each expense ratio quartile. Past performance is no guarantee of future results. See Data appendix for more information.
US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago.

The higher a fund’s costs, the higher its return must be to stay competitive. Investors may be able to reduce the odds of picking a persistent loser by avoiding funds with high expense ratios.
 The sample includes funds at the beginning of the five-, 10-, and 15-year periods ending December 31, 2014. Funds are ranked by quartiles based on average expense ratio over the sample period, and performance is compared to their respective benchmarks. The chart shows the proportion of winner and loser funds within each expense ratio quartile. Past performance is no guarantee of future results. See Data appendix for more information. US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago.

The sample includes funds at the beginning of the five-, 10-, and 15-year periods ending December 31, 2014. Funds are ranked by quartiles based on average expense ratio over the sample period, and performance is compared to their respective benchmarks. The chart shows the proportion of winner and loser funds within each expense ratio quartile. Past performance is no guarantee of future results. See Data appendix for more information.
US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago.

Fund expense ratios range broadly across both equity and fixed income funds. For example, in the five-year period, equity funds in the lowest quartile cost investors an average of 0.51%. The most expensive quartile, at 1.68%, had an average cost that was more than three times higher. The range is just as wide in fixed income, with the lowest quartile charging 0.26% vs. 1.06% for the highest quartile during the five-year period.

Are investors receiving a better experience from higher-cost funds? The charts suggest otherwise.

Especially for longer horizons, the cost hurdle becomes too high for most funds to overcome. 

Over 15 years, 29% of the lower-cost equity funds outperformed, compared to only 9% of the higher-cost equity funds. Similarly, for fixed income, only 11% of the lower-cost funds and 2% of the higher-cost funds outperformed.

The research suggests that high fees can contribute to underperformance. The higher a fund’s costs, the higher its return must be to stay competitive. Investors may be able to reduce the odds of picking a persistent loser by avoiding funds with high expense ratios. 


Data Appendix

US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago.

Certain types of equity and fixed income funds were excluded from the performance study. For equities, sector funds and funds with a narrow investment focus, such as real estate and gold, were excluded. Money market funds, municipal bond funds, and asset-backed security funds were excluded from
fixed income.

Funds are identified using Lipper fund classification codes. Correlation coefficients are computed
for each fund with respect to diversified benchmark indices using all return data available between January 1, 2000, and December 31, 2014. The index most highly correlated with a fund is assigned as its benchmark. Winner funds are those whose cumulative return over the period exceeded that of their respective benchmark. Loser funds are funds that did not survive the period or whose cumulative return did not exceed their respective benchmark.

Expense ratio ranges: The ranges of expense ratios for equity funds over the five-, 10-, and 15-year periods are 0.01% to 4.89%, 0.01% to 4.53%, and 0.04% to 4.83%, respectively. For fixed income funds, ranges over the same periods are 0.01% to 2.78%, 0.05% to 2.55%, and 0.03% to 3.66%, respectively.

Portfolio turnover ranges: Ranges for equity fund turnover over the five-, 10-, and 15-year periods are 1.0% to 1,499.4%, 1.0% to 1,524.0%, and 2.0% to 2,400.4%, respectively.

Benchmark data provided by Barclays, MSCI, Russell, Citigroup, BofA Merrill Lynch, and S&P. Barclays data provided by Barclays Bank PLC. MSCI data © MSCI 2015, all rights reserved. Russell data © Russell Investment Group 1995–2015, all rights reserved. Citigroup bond indices © 2015 by Citigroup. The BofA Merrill Lynch index is used with permission; © 2015 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Merrill Lynch, Pierce, Fenner & Smith Incorporated is a wholly owned subsidiary of Bank of America Corporation. The S&P data is provided by Standard & Poor’s Index Services Group.

Benchmark indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.

ENDNOTES
1. Bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset

and the lowest price for which a seller is willing to sell it.

2. Fixed income funds are excluded from the analysis because turnover is not a good proxy for fixed income trading costs. 

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