The Hurdle of Higher Costs
Living in Hong Kong has encouraged me to be much more cost conscious than I ever was back in Toronto. Is that HKD140 cocktail worth it or would Club 7 Eleven do the trick? If I have legit designer shoes can I get away with a knock-off dress? Do I really need to grocery shop at Great or can I just devour their samples and hightail it to Wellcome? Despite my expensive tastes, the lower cost solutions usually reign supreme. Research shows that the same goes for fund selection.
We all want to pad our portfolios with funds that will outperform their benchmarks. But how much should investors be willing to pay for expected outperformance? Chances are, that expensive, shiny-looking star manager will end up underperforming in the longer term. This is partly due to the drag of high costs, which lessens an investor’s net return and imposes a significant hurdle for a fund to outperform.
Consider the effect of expense ratios on fund performance. Recent research by Dimensional Fund Advisors (DFA) indicated that US-domiciled mutual funds with the highest expense ratios had the lowest rates of outperformance. This was especially apparent over longer time horizons.
Take US-domiciled equity funds for example. Over the 5-year period through 2016, DFA found that only 20% of equity funds with high expense ratios outperformed their benchmarks. This is less than half of the 42% outperformance rate of their low expense ratio counterparts. It gets worse over longer time periods: over the 15-year period through 2016, only 9% of the high expense ratio equity funds outperformed their benchmarks versus 28% for their low expense ratio counterparts. The research showed a similar yet more moderate pattern for US-domiciled fixed income funds.
Costs are also a meaningful hurdle to overcome for EU mutual funds, according to a recent study by the European Securities and Markets Authority (ESMA). Between 2013 and 2015, fees and one-off charges reduced investors’ returns by 20% of gross returns on average. However, the investor experience can vary widely across asset classes, management style, investor type and jurisdiction. Overall, ESMA found that the negative impact of costs on the performance of actively managed and retail funds tend to exceed those of their passively managed and institutional counterparts. This is mainly attributable to higher total expenses, with sales fees acting as a further driver.
Bottom line: Investors should be mindful of the hurdle of higher costs in the pursuit of higher expected returns. We believe choosing lower cost solutions built on academically proven drivers of return is the way to go.
 US Mutual Fund Landscape 2017, Dimensional Fund Advisors. Research sample based on US-domiciled open-end mutual funds. Index funds and fund-of-funds are excluded from the sample.
 The impact of charges on mutual fund returns, ESMA Report on Trends, Risks, and Vulnerabilities, Issue 2, 2017.