Role of fees in mutual funds: Is it exaggerated?

Question

It seems to me that the role of fees in mutual funds is somewhat exaggerated. Say, if funds A and B charge 1.3 and 0.3 percent, respectively, and over a period of 10 years the annualize return of A and B are 10% and 8.5%, it makes sense to pick A over B although it charges more. I have seen quite a few funds that outperform SPX by more than 1% over a period of 10 years or even more) and have fees below 1%.

Answer 1

The problem you have is picking the fund that can overcome the higher fees to beat the low cost index fund. You have to know which funds will over the next 10 years beat the index by enough to overcome the higher fees.

If the only way to know is to look back, then you are likely to have picked wrong.

Also make sure that you are looking at all the fees. Some are due to transaction costs, others due to having to pay for research, and a larger staff. Don't ignore the costs of taxes if the money isn't in a tax free or tax deferred account.

Answer 2

There are two problematic assumptions in your post:

1. You assume that funds with higher fees have higher returns. And even more, you assume that their higher returns are exceeding the fees. In such a case it would indeed be foolish to look at costs. However, the evidence for persistence of skill in investing is pretty weak and mostly applies to niche markets. And on top of that, you would need to pick the better funds beforehand, without a long-running track record. And to make things worse, funds are organizations not persons. A skilled fund manager might just switch to a competitor next month and you have no way to know this beforehand
2. You assume that small differences in cost matter only little. "just 1%" per year will compound and the longer you invest the larger the difference will get. If you are investing for retirement that tiny 1% difference can easily make a 30% difference between both funds, assuming the same performance before costs. And that is basically what is actually measured in things like the SPIVA

Answer 3

The problem here is that you're thinking of it as 1%.

However, lets figure you're making 8% on your investment. 1% is 12.5% of that. The high-fee fund has to be 12.5% better just to keep even. Oops, got too simple with the percentages. The low-fee fund gives you 7.7% while the high-fee fund gives 6.7%. The high-fee fund has to be 15% better to match the performance of the low-fee fund.

Answer 4

I tend to agree with the OP's assertion. Six years ago I started an experiment to test indexed funds versus managed funds.

Here are the data, where fees are "Gross Expense Ratio" and returns are labeled "Average Annual Total Return" by my provider and are since inception:

The format is fund name and description, type of fund, return, fees, and how well the fund does versus a fictitious fund that always gains 10% every year. This last factor is multiplicative, meaning if the fund would have returned 50% more than the fictitious 10% fund over my 6-year time frame, the factor would be 1.50, while if it would have returned less than a 10% guaranteed yearly return fund, the factor will be less than 1.

US Large Cap Growth, Managed, 21.49, 0.32%, 1.78

US Large Cap Stock, Indexed, 16.62, 0.01%, 1.42

US Small/Midcap Stk, Managed, 14.78, 0.58%, 1.25

US Small/Midcap Stk, Indexed, 13.63, 0.01%, 1.21

US Large Cap Value, Managed, 13.31, 0.28%, 1.17

Fictitious 10% Return/Year, 10.0, 0.0%, 1.00

Emerging Markets Indexed, 8.55, 0.09%, 0.92

Developing Markets Indexed, 7.79, 0.03%, 0.88

A good example to look at is the small/midcap funds in the middle. The managed fund has a slightly higher yearly return (14.78% versus 13.63%) than the indexed fund while charging a fee that is 58 times as high. Yet it still is the superior investment over the 6 year time frame of this experiment. The point is that if you overemphasize fees you will miss some great performers.

Now this is a small data sample. As others have pointed out, there is no way to know in advance which managed funds will perform well. However, you won't ever reap the big returns unless you take some risks. While the fees seen above for managed funds are relatively large in comparison to the indexed fund fees, the managed funds have more than paid for themselves as a whole and have clearly outperformed the indexed funds.

Again as others have said, you have to wonder if this will hold up in the long term - say a 10 or 20 year time frame, where managers' performances have not been consistent, and the market performs worse than it has in the last 6 years.

Still, I argue that the concept of diversity should include some managed funds. It can really pay off. We all know the fundamental rule of investing: Greater returns require greater risks.