Defending high fees is taboo even for those who advocate active management. Some may refer to Warren Buffett’s adage ‘price is what you pay and value is what you get,’ but that still implies a relationship whereby a high price could erode value.
It is far more difficult to argue that a high price is what you pay and quality is what you get; mutual funds have yet to match other purveyors of luxury goods in mastering that marketing alchemy.
A study published in February – by Jinfei Sheng and Terry Zhang of the University of British Columbia’s Sauder School of Business and Mikhail Simutin of the University of Toronto’s Rotman School of Management – may help them do so.
The authors noted the wealth of literature documenting a negative effect on fund performance from high fees, but wondered how such products could nevertheless continue to exist in a competitive market.
The cynical response is that investors are uninformed, lethargic or apathetic, traits exploited by predatory brokers. Yet, that does not explain why so much ‘smart money’ is still allocated to relatively high-fee strategies – without even mentioning hedge funds – as evidenced by the size of many institutional share classes.
Sheng, Zhang and Simutin’s insight was to apply a factor-based analysis to the portfolios of higher-fee funds. They found that while high-fee funds did generally underperform on a four-factor model, incorporating the newer ‘investment’ and ‘profitability’ factors – respectively, that stocks with a high operating profitability perform better and that stocks of companies with high total asset growth have below-average returns – changed the picture.
Their dataset was actively managed US domestic equity funds, with a sample of almost 2,500 funds between 1980 and 2014 from the CRSP Survivor-Bias-Free US Mutual Fund Database, with portfolio information from the Thomson Reuters Mutual Fund Holdings Database. The mean expense ratio was 1.23% and the median 1.2%, with a range from 0.09% to 3.53%.
The academics confirmed that under three- and four-factor models, fund performance was unrelated to fees – higher charges did not yield higher returns. However, once the five-factor model was used, the difference in alpha between the top and bottom fee deciles was economically large at 0.9% per year and statistically significant. Their findings suggested that funds that charge 1% higher fees deliver 1% more alpha.
To discover why this should be the case, the researchers delved into the portfolio data. This revealed that, relative to stocks held by funds in the lowest fee decile, companies owned by funds in the top fee decile grew their assets at a faster rate (by 19% versus 12% annually), issued more equity (4% versus 2% of market capitalization) and had lower gross profit ratios (28% versus 34%).
Stocks with these characteristics – higher asset growth, higher equity issuance and lower profitability – tend to be mispriced by four-factor models, which focus instead on size and value.
Free for all
‘Before deducting expenses, high-fee funds have been found to perform just as well as do low-fee funds,’ summarized Sheng, Zhang and Simutin. ‘Theoretically, this result is puzzling, as it suggests managers of high-fee funds extract more rents than the value they add. Empirically, the apparent negative relation between expenses and net-of-fees performance has helped guide allocations of billions of dollars of retail and institutional investors, who shun high-fee funds. The relation is also puzzling as it calls into question the continued existence of high-fee funds.
‘The results we obtain stand in stark contrast with those in the prior literature,’ they continued. ‘We find high-fee funds significantly outperform low-fee funds before deducting expenses, and do equally well net of fees. Our findings support the theoretical prediction that skilled managers extract rents by charging high fees, and call into question the widely offered advice to avoid high-fee funds.’
The lesson investors should draw, however, is emphatically not that higher fees guarantee higher returns. Rather, this work underlines the importance of understanding the underlying factor exposures in active portfolios. A high-fee fund may be a high-alpha fund, or it may simply be a high tech fund.