Key Points

  • Higher fees tend to correlate with worse investment performance, as suggested by research from Vanguard based upon the historical analysis of active and passive large-cap mutual funds.
  • Research suggests that the lower the fees, the less likely that a fund will underperform its benchmark (which is good for the investor).
  • Sound investing comes down to being able to differentiate between what you can control and what you can’t, and then doing your best to focus on the former while still maintaining a solid understanding the risks associated with the latter.
  • Given that you can control how much you pay in fees, but not whether a fund will outperform, a passive approach has strong merit over an active one.

Bang for Your Buck

In Part 3 of this series, we left off with the understanding that the fees for actively managed funds are substantially higher than those for passively managed funds. So are those higher fees actually worth it? Let’s see.

At a high-level, you may be thinking that higher fees would be associated with better performance. After all, that’s the whole point of higher fees, right?

Nope.

Based upon this study from Vanguard, on average, higher fees are actually associated with worse performance, as suggested in Figure 1 below.

2018-09-19-Excess Returns versus Fees

Figure 1. Ten-Year Excess Returns from Stated Benchmark (Y-Axis) versus Stated Fees (X-Axis) as of December 31, 2017 (Footnote 1: Vanguard.com)

Let’s digest Figure 1 one step at a time, as its message is crucial to understand. First off, each dot represents a different U.S. large-cap mutual fund; the blue dots are actively managed funds, while the red dots are passively managed index funds.

“Large-cap” simply means these funds invest in the largest subset of publicly traded companies, which in the U.S. is essentially the companies that make up the S&P 500® Index. For example, the smallest company in the S&P 500® Index has a market cap (i.e., the market value of the company’s stock) of over $6 billion dollars.

The three charts themselves in Figure 1 represent mutual funds that invest in different subsets of these large-cap stocks. The chart on the left represents funds that invest in value stocks; while the chart on the right represents funds that invest in growth stocks; while the chart in the middle represents funds that can invest in any large-cap stock (i.e., a blend of value and growth).

We’ll dive into the distinction between value and growth stocks when we’re further down the road, but for now you can think of a growth stock as a stock for a company that is expected to grow very quickly, such as a high-tech firm in its earlier years. On the flip side, a value stock tends to represent a stock from a more established firm, such as a railroad company that’s been operating for decades.

Digging Deeper

The X-Axis (which runs horizontally) in Figure 1 represents annual expense ratios for a given mutual fund. This axis ranges from 0% to +3%. So a $100k investment with a 3% expense ratio can expect to pay about $3k each year in fees (even if the fund is down!). The exact amount charged will depend on the account value of the investment at the time the fees are collected.

The Y-Axis (which runs vertically) represents the relative underperformance or outperformance of a given mutual fund to its target benchmark. This axis ranges from -15% to +15%. The black, horizontal center line on each chart represents no outperformance. Thus, dots above this line represent funds that did better than their stated benchmark (which is good for the investor); while dots below this line represent funds that did worse than their stated benchmark. The notion here is that each mutual fund has a benchmark that it’s trying to match (in the case of a passively managed fund) or beat (in the case of an actively managed fund).

For instance, let’s say you found a passively managed S&P 500® index fund. The benchmark for this fund would clearly be the S&P 500® Index. This passively managed fund might actually go to the market and buy the stock for each of the 500 companies in an attempt to closely match the daily movements of the S&P 500® Index, whose value and constituents are published and readily available. Thus, the relative outperformance (and underperformance!) of this passive fund to its benchmark should be close to zero.

On the other hand, let’s say you found an actively managed fund, whose benchmark was also the S&P 500®. This actively managed fund might have a team of investment professionals that deeply investigates each company within the S&P 500®, while only investing in those that they think will actually provide a greater risk-adjusted return than the S&P 500®. Thus, the relative outperformance of this active fund to its benchmark should be greater than zero.

This measure of relative outperformance is termed excess returns, i.e., the returns that are in excess of a given benchmark, and another name for excess returns is alpha. Thus, if the excess returns are greater than zero, then the fund had a positive alpha, which is good. However, if the excess returns are less than zero, the fund had a negative alpha, which is bad.

The straight, colored line (which is slanted downward as it runs from left to right on each chart) represents a linear regression, or a best-fit trend line, i.e., a general relationship of expenses to returns within each chart.

Initial Insights

Given all this, here’s what we can decipher from these powerful charts:

1) There are clearly more dots below the black center line in each of the three charts. This means that on average, most funds do not provide value in the form of outperformance.

2) In fact, the higher the fee the greater the underperformance (which is bad for the investor). This means that the lower the fees the less likely that a fund will underperform its benchmark (which is good for the investor).

3) Passive funds show smaller variability in their performance as compared to active funds. This means that active funds are more likely to deviate from the colored line by a significant amount (both over and under).

Inferences and Conclusions

Essentially, higher fees seem to correlate with lower performance. Silly, right? But you might be thinking, active funds can still make sense because they provide the ability to end up above the black line.

The problem with this notion is that it’s basically a gamble; meaning, yes by good luck you might just end up above the black line. But, given that there are more dots below the black line, it’s more likely that you’ll end up below the black line. Just like in a casino: you might end up with more money than you had when you started, but more often than not, you’ll end up with less. And the more you keep playing, the better your chances of losing money overall. The odds are simply not in your favor.

Sound investing comes down to being able to differentiate between what you can control and what you can’t, and then doing your best to focus on the former while still maintaining a solid understanding the risks associated with the latter.

Applying the above notion to the situation of deciding where to invest can lead us to a sensible conclusion. Basically, we can control how much fees we pay, so why not pick a fund with lower fees?

However, we can’t control whether a given fund will end up above the black line, so to minimize the chances of being far below the black line (which would be bad for an investor), we would be better off picking a passive fund over an active fund.

Summary

In summary, based upon the information that we can glean from Figure 1, it behooves an investor to invest in a passive fund with the lower fees, as opposed to an active fund with higher fees.

And I know what you’re thinking–why not just invest in dots that are above the black line? If only investing was that simple. Believe me, it’s been tried, and it doesn’t work. In fact, there are funds (known as Fund of Funds) whose main objective is to do just that; i.e., invest in funds that are more likely to outperform their benchmarks. But as it turns out, consistently picking above “black line funds” is also very challenging (read: impossible). However, we’ll need to cover this line of thinking in greater detail in a future post to do this topic justice.

Therefore, as we have seen above, not only do active investments charge higher fees, but also they tend add less value the more they end up charging. Clearly, from this perspective, it’s better to be passive.

But just how much does this all really matter in the grand scheme of things? The answer will make you fall off of your chair. So have a seat, and check out Part 5 for a deeper dive into the long-term impact of higher fees.

Footnote 1: Vanguard.com, Higher expense ratios were associated with lower excess returns for U.S. funds: As of December 31, 2017.

Each fund is plotted to represent the relationship of its expense ratio (x-axis) versus its ten-year annualized excess return relative to its stated benchmark (y-axis). The straight line represents the linear regression, or the best-fit trend line–that is, the general relationship of expenses to returns within each asset group. The scales are standardized to show the slopes’ relationship to each other, with expenses ranging from 0% to 3% and returns ranging from -15% to 15% for equities and from -5% to 5% for fixed income. Some funds’ expense ratios and returns go beyond the scales and are not shown.

Sources: Vanguard calculations, using data from Morningstar, Inc. All data as of December 31, 2017.