Low Fund Costs Predict Better Future Returns

The debate over the benefits of active investment management versus passive investing remains a favorite topic of investors.

Whenever new data emerges to buttress the long-established argument that index funds, which use passive investing, outperform on all measures compared to active-funds, the strategy gains more attention.

The latest data comes from Bank of America Merrill Lynch that found that only 23% of large-cap managers beat the Standard & Poor’s 500 and 27% beat the Russell 1000, as cited in its Investment Advisor, 2010 report.  This comes after another report based on UK managers found that over two-thirds of UK equity managers under-performed the FTSE All-Share index over the past three and five years, according to Morningstar.

Numerous academic studies going back decades have failed to prove the cost-performance-risk benefits of active management, much to the delight of John Bogle, who helped develop and promote the indexing strategy for Vanguard.

Another problem is that up to one-third of active fund managers who charge shareholders for active management have been found to be “closet indexers,” which means they are investing in stocks or ETFs to mimic and index and then seeking to add outperformance by carefully choosing stocks.  This is enhanced indexing, distinct from active management, and should not cost investors the same as actively–managed funds.

What Makes Passive Investing Attractive

So what makes passive investing so attractive?

Basically, it is due to the structure and goal of indexing.  In practice, this means that passive investing (as opposed to actively choosing stocks or an index ETF (exchange traded fund) that will outperform and increase in value over time creates a portfolio of stocks designed to deliver the performance of a specific index.  This portfolio is built because, on average, all funds together can only deliver the return of the market. This includes stocks that gain and lose, thus mirroring the performance of the entire index.

Another key reason why index fund outperform is due to their cost structure. This can be found by comparing the gross returns of active versus passive funds.

Actively-managed fund returns suffer from the costs of higher management fees needed to cover research costs, higher trading costs as the managers re-direct their portfolios in the hopes of beating the market, revenue sharing, 12b-1 fees, and other high sales costs.  Over time, these costs add to the total expense ratios of actively-managed funds and make it more difficult to beat an index.

In contrast, passive funds and many index ETFs eliminate or better manage many of those costs, so a passive fund can start from costs as low as 0.15% upwards.

It also has to be noted that comparisons between active and passive strategies vary by the market sector (small cap versus international), but while the results may differ, the results definitely favor indexing in almost all time periods and market sectors.

For example, in this chart, T. McGuigan (2006) compared the performance of actively managed funds to the S&P 500 Index over the 20-year period to 2003. He concluded that the longer the investment period, the greater the odds that the active manager would fail to beat the index fund.  The percentage of U.S. large-cap and mid-cap funds that outperformed the index over the period was only 10.6% and 2.6%

Large-cap U.S. mutual funds performance vs index funds

Source: McGuigan (2006)

Low Costs Predict Future Success

While Morningstar has a new rating system, and Lipper assigns stars to the funds it examines, the odds of future performance are bleak.  McGuigan* (2006) examined funds that were in the top quartile of performance during 1983 to 1993 and again during the period to 1993 to 2003. He found that only 29% remained in the top quartile, 33% of the funds dropped to the second quartile and the remaining funds dropped to the third or fourth quartile.

A critical variable is performance from many studies is cost or a fund’s total expense ratio.  This is why investors have to know how their mutual fund company sells their funds since these costs are passed onto investors in the form of the fund’s total expense ratio.

When a fund employs a national sales force comprised of mutual fund wholesalers, their internal support staffs, key account and project managers, and other financial rep customer contacts, it is all paid for by the fund distributor.  This adds to the fund’s total costs, which are then ultimately paid for by shareholders.  “In fact, low costs have been proven to be a more reliable indicator of performance that past returns,” according to Paula Niall.

Active managers now say that non-trending marketing, greater volatility and the risks of “headline,” or short-term events, have made their jobs more difficult.  This is understandable and offers some hope that some active managers have valid strategies that deserve the attention of investors.

There is even a good marketing opportunity for active managers to adopt a sliding performance compensation scale to attract new investors.  This hurdle rate used in hedge funds has a role in active funds.  Investors would pay for performance, but it is reasonable to expect them to pay less, or nothing at all, if a manager fails to beat a benchmark.

The burden, however, is on those managers to state their cases, better define their mutual fund strategies and organizations and explain to the investing public how they monitor and contain costs, advocate transparency and avoid using expensive national mutual fund wholesaler sales forces that do not benefit shareholders.  Active managers who make this case and engage in serious marketing-education deserve to be heard by serious retail investors.

*Source: T. McGuigan, (2006). “The Difficulty of Selecting Superior Mutual Fund Performance”, Financial Planning Association Journal, February, Article 6.