I'm fed up with hearing how people should look at the expense ratios of mutual funds when deciding which to invest in as if that was the most important factor. I just turned off a radio show I was listening to because the host was going on about this again. There is so much propaganda out there that I think a lot of people think that these costs are deducted from the reported mutual fund returns. This is not the case. Mutual fund returns are always reported after all costs. Therefore, what is of first order importance is the return not the cost. Vanguard use the line "if you don't get to keep it is it really yours" to try to get people to believe otherwise.
The argument that costs are important is based on the unproven theory that the market is totally efficient and no managers add any value. In such a world the best fund would be the one with the lowest expenses. But that isn't the world we live in. Managers can add value but most don't on average add more than their fee which is what we would expect from economic theory. However, there are some managers that do add a lot more value than their fees. On the other hand, the average individual investor won't have the neccessary insights to pick these out.
Index type funds do have an advantage of being very tax efficient relative to most actively managed funds. This is irrelevant, however, in US retirement accounts (not in Australia though where retirement account earnings are taxed at 15% at source - but a levered managed fund can end up being even more tax efficient under Australian tax rules!).
Even when choosing among index funds, the expense ratio isn't the most important thing. A fund which charges high expenses should lag the index. Looking at the reported returns is good enough. Perhaps the higher cost fund manages to offset those costs by slightly outperforming the index before costs.
Loads - the entry fees into funds are another matter. These are there in order to provide commissions for brokers. The very high rates are a throwback to the times when the cost of trading stocks were also very high (though never that high) just like trading property still costs several percent. I would try to avoid paying a load unless a fund was very interesting and there was no way around it. For example, the Australian fund manager Colonial First State charges a load of 4% on its equity funds. If you make an application direct to the firm you pay that fee and they just pocket it. If you apply through a full service broker the broker gets the fee. If you buy it through a discount broker like CommSec the broker rebates the fee to you and you pay no load! (I have accounts with both these firms).
6 comments:
You are absolutely right that the only return investors care about is the bottom line return, net of expenses. If a mutual fund manager charges high fees to get me a higher total return without taking on additional risk, great! He deserves the money.
The efficient market theory is indeed unproven. No theory can ever be proven true. But your argument here about the efficient market being unproven is a red herring. You got close when you said: "Managers can add value but most don't on average add more than their fee." Actually, most managers don't add ANY value, regardless of the fee.
Do we agree that the return of the underlying assets of a fund is its net return plus expense ratio?
Studies (admittedly biased studies from Vanguard) have shown that as the expense ratio increases, managers get worse at picking stocks. Rather than rely on biased research, I invite you to check this out. Create an Excel spreadsheet with fund return, expense ratio, and return of underlying assets (return + ER). Then run a linear regression and see what pops out.
But what about the managers that do add value? It's luck. If manager skill were involved, investors could use the hindsight of past performance to pick them out. Most managers don't beat the market for any significant period of time. Those that do come out ahead of the market usually do so by taking on more risk than the market. The rest is just statistical noise.
It's an amazing kind of luck that generates the kind of track records that managers like Warren Buffett have generated.... admittedly Berkshire Hathaway isn't an investment fund per se just a well known example of money management. Even the record of Soros and Druckenmiller over many years could be just due to more risk - otherwise the downsides would also be bigger. If there is no alpha out there why is portable alpha such a big thing currently?
Alright, I agree with you that if you find the right manager, you can not worry about the "expense fees". However I think the big reason the whole low expense thing is out there is not really meant for the truely financial smart people. It is for the average Joe. The same Average Joe who does not put at least enough to match into his 401K (another very overused statement) the Average Joe who is in debt (even more articles on how to get out of debt). Rather it is for the people who want low maintenance when it comes to investmets, not someone like you who has their own blog on their finances and maybe even me- one who responds to your blogs. People who do not want to put a whole lot of energy into it.
That is my reason why the articles are out there, and why they seem to make sense to me.
woops, I had a lot of mis-spelled words up there, but what my point was that people like you, where obviously you have a passion for investing and researching the best way to invest, is not the real norm, and for those "norm" people index-low maintenance fee funds are right for them
I checked out the analysis that the guys at TFS Capital sent me. The US equity funds that had higher risk adjusted returns (alpha) than TFS's Market Neutral Fund had an average expense ratio of 2.5%. They also tended to be very small. It's the smallness of the funds that probably lead to their strong performance and resulted also in a high expense ratio.
For people who are not very interested or able to get into investing in any serious way, it probably does make sense to recommend they build a portfolio from index funds. I guess what I am asking is I'd like to see an analysis that shows that index funds with higher expense ratios actually don't track the index. If they don't that is a problem. But I suspect they find ways to get around the drag caused by the higher expenses. The argument then is that you'll beat more than half of all mutual funds by getting an index fund and not have to worry about monitoring managers' performance over time.
PS - indexation continues to make headway - head yesterday that our university has shifted more of its endowment assets away from venture capital etc. and towards indexing. I don't get to see any of the numbers though...
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