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Costs matter

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.

Before a fund can outperform, it must first add enough value to cover its costs. All mutual funds incur costs. Some costs, such as expense ratios, are easily observed while others 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 data shows that many mutual funds are expensive to own and do not offer higher value for the higher costs they incur. 

Let’s consider how one type of explicit cost - expense ratios - can impact fund performance. In the chart below, equity funds in existence at the beginning of the one, five and ten year periods are ranked into quartiles based on their average expense ratio.

Fund expense ratios range broadly. For the one year period (2012), the median expense ratio was 1.1% for equities. In 2012, funds in the lowest quartile cost equity investors an average of 0.48%. The most expensive quartile, at 1.66%, had an average cost that was three times higher. 

Are investors receiving a better experience from higher-cost funds? The data suggests otherwise. This is especially true over longer horizons, when the cost hurdle becomes too high for most funds to overcome. Over the five-year period, 31% of the low-cost equity funds outperformed versus 17% of the high-cost funds. Over a 10-year period, 21% of the low-cost funds outperformed versus only 10% of the high-cost funds.

             expense-ratios-compared

The cost of an investment is a factor that many fail to adequately account for when constructing an investment strategy and portfolio. When considering the performance of an investment, one should always consider the costs involved. 

According to a research conducted by the Financial Services Authority (now the Financial Conduct Authority) back in 2000, one "must invest about £1.50 in an actively managed unit trust or through a life office in order to obtain the market rate of return on £1; and that obtaining the market rate of return on £1 requires an investment of about £1.10 to £1.25 in an index tracker.” [1]

Its hard work to run an actively managed fund that consistently beats the market. In an effort to achieve this, there are a number of strategies which can be employed: top-down, bottom-up, event-driven, value and growth investing, technical or fundamental analysis and the list goes on. 

While many of these strategies may differ, a common element through all of them is that the active manager needs to draw upon a team of highly skilled individuals in order to conduct and implement these strategies. This will of course come at a cost and as a result the fund must charge a higher premium, essentially raising the level of performance required to offer the investor a return above the benchmark  [2]. 

Coupled with this, there have been a number of recent academic articles suggesting that there are very few active managers who, on average, have the ability beat core market benchmarks, specifically when costs are taken into account [3].

We take the negative impact that costs can have on your investment portfolio very seriously. As a result, we have specifically constructed our portfolios with this issue in mind. In line with this, our strong focus toward the passive, and smart beta environment helps to minimise costs without the risk of under performance.

http://www.ft.com/intl/cms/s/0/cb5a29da-acc7-11e2-b27f-00144feabdc0.html#axzz3D7FzL2cG


 

[1] James, K “The Price of Retail Investing in the UK” 2000

[2] French, K (2008) Cost of Active Investing

[3] Carhart, M (1997) On Persistence in Mutual Fund Performance; Jones, R & Wermers, R (2011) Active Management in Mostly Efficient Markets; Malkiel, B (2005)

 


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