Funds with high expense ratios rarely earn back their expenses. This implies investors should hold low-cost index funds.
Expense Ratios
Does your portfolio hold mutual funds or exchange-traded funds? Many of us invest in mutual funds and exchange-traded funds (ETF's), whether they are actively-managed funds or passively-managed index funds. Funds charge shareholders an annual fee. Such a fee pays for the management and operating expenses of the fund. It is typically a percentage of the average net assets of the fund over a year and is called the expense ratio. The return a shareholder receives, then, is the gross return earned by the fund minus the fund’s expense ratio.
Benchmarks and Measuring Performance
In order to facilitate the discussion of expense ratios, let's introduce the concept of a benchmark. For each mutual fund and ETF, a unique benchmark may be constructed. A fund's benchmark (1) is an unmanaged index of securities which an investor could hold at a very low cost and (2) has exactly the same investment risk as the fund. A fund's benchmark thus represents a low-cost, risk-matching alternative to the fund itself. If a fund’s net return is higher than its benchmark’s return, then the fund has provided value by delivering a return to the shareholder in excess of the return the shareholder could have received by holding a low-cost unmanaged index with the same risk.
However, a large body of evidence collected over decades suggests funds do not beat their benchmarks. Instead, funds generally underperform their benchmarks to the extent of their expense ratios (this finding is not altogether surprising given that funds as a whole earn roughly the market’s return minus fees and trading costs and those funds that charge less are more likely to come closer to their benchmarks than those with high costs). The implication of this result is that among funds with the same investment objective or style, investors should select the funds with the lowest expense ratios. For example, among US small capitalization/value stocks, the expense ratios of funds range from below 0.10% to almost 2.00%; so which fund would you invest in?
As the example illustrates, expense ratios vary considerably. Here are average expense ratios for selected investment styles: Large-Cap Stock Funds: 1.25%. Mid-Cap Stock Funds: 1.35%. Small-Cap Stock Funds: 1.40%. Foreign Stock Funds: 1.50%. Bond Funds: 0.90%.[1]
Conclusion
So are investors on average paying too much for a fund? In a word, yes. In each of these style groups, well-run funds are available with significantly lower costs. How low? The average expense ratio of the funds held by Freshfield is 0.12%.
We can summarize this discussion with a quote from Vanguard founder Jack Bogle: You get what you don’t pay for.
Dr. Andy Lawson is the principal of Freshfield Investments, a Registered Investment Advisory firm in Plano, Texas serving clients locally and nationwide. Freshfield provides investment management and financial planning as a fee-only, fiduciary. To book a virtual or in-person complimentary consultation, please visit our Contact page.
[1] The data source is Morningstar's mutual fund and ETF database, 12/31/2018