Hedge fund fees have long been thought of as the prime example of asset managers ripping off investors. Of course, not everyone views them so negatively. The proverbial ‘two and 20’ – the standard 2% annual hedge fund management fee plus 20% of any profits – has made mutual funds salivate. As one mutual fund manager once put it to me, ‘I’m a bargain at 2% because I’m not charging a percentage of gains on top of that.’
Since the financial crisis, hedge fund envy has declined and fee compression has increased. But some mutual funds’ effective performance fees (EPFs) remain excessive, according to Sam Lee, a former Morningstar analyst and founder of SVRN Asset Management in Chicago. In a June 2016 issue of Mutual Fund Observer, Lee defined EPFs as the expense ratio expressed as a percentage of the fund’s gross excess return. The gross excess return itself consists of any outperformance over its index added to its expense ratio.
The EPF is not a hidden fee that fund managers charge on top of those disclosed in the prospectus. Instead, it is a way of expressing what percentage of the outperformance is eaten up by the expense ratio.
So if a fund returns 1% after fees, and charges a 0.5% expense ratio, its gross excess return is 1.5% and its effective performance fee is 33%. Investors should note that, sadly, an EPF below 50% is rare, so it’s common to give those few managers who generate any outperformance half of what they have returned.
Actively managed large-cap funds their indices over 15 years
|Average return for outperformers||Average outperforming expense ratio||Outperformance over index||Gross excess return||Effective performance fee (%)|
|Average Outperforming Large Blend (54 of 186)||9.83||0.83||0.77||1.6||52|
|S&P 500 TR||9.06|
|Average Outperforming Large Growth (78 of 244)||10.91||0.97||1.16||2.13||46|
|Russell 1000 Growth||9.75|
|Average Outperforming Large Value (50 of 174)||9.45||0.79||0.7||1.49||
Source: Morningstar Direct
Not earning their keep
With data from Morningstar, I have examined all actively managed large-cap funds (value, blend and growth) for the past 15 years to August 2017, determining any outperformance over the S&P 500, Russell 1000 Value and Russell 1000 Growth indices, and calculating gross excess return and EPF. The data is riddled with survivorship bias. But this just helps to show that outperformance – where it exists – is so small that further fee compression is justified.
In my study, only 182 of 604 funds – or around 30% – beat their relevant indices. That’s a stunning indictment for a list of funds benefiting from survivorship bias. More than half the funds failed to outperform over a period exceeding one full market cycle. Where it existed, the outperformance was meager, with the average margin of victory among the outperforming funds coming at between 70 and 116 basis points. And the outperformers charged nearly half of that – taking between 46 and 53 basis points, depending on the Morningstar category.
Given the run that the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) have had recently, some growth funds have produced attractive results. For example, the Fidelity OTC fund has returned 13.47% annualized over the past 15 years, adding 372 annualized basis points (bps) against the Russell 1000 Growth index. That fund’s 0.9% expense ratio results in a 19% EPF. Also, the Vanguard Capital Opportunity fund produced 361 bps of outperformance over the index over the past 15 years, and its rock-bottom 0.45% expense ratio led to an 11% EPF.
Among the large blend funds with higher EPFs were DFA Enhanced US Large Company and JP Morgan Disciplined Equity. They clocked in with effective performance fees of 90% and 88% respectively. American Century Equity Income, a popular large value fund, also had an effective performance fee that consumed more than 90% of its gross excess return.
The mutual funds with the biggest EPFs
|Name||Ticker||Morningstar Category||Total annualized return – 15 Yr (%)||Sharpe ratio – 15 Yr||Sortino ratio – 15 Yr||Annual reported net expense ratio – 2016||S&P 500 total return (%)||Russell 1000 Growth total return (%)||Outperformance over S&P 500 index||Gross excess return||Effective performance fee (%)|
|DFA Enhanced US Large Company I||DFELX||US Fund Large Blend||9.09||0.6||0.88||0.23||9.06||9.3||0.03||0.26||90|
|JPMorgan Disciplined Equity L||JPIEX||US Fund Large Blend||9.12||0.6||0.88||0.45||9.06||9.3||0.06||0.51||88|
|JPMorgan Large Cap Growth I||SEEGX||US Fund Large Growth||9.77||0.61||0.91||0.89||9.06||9.75||0.02||0.91||98|
|Pioneer Fundamental Growth A||PIGFX||US Fund Large Growth||9.79||0.7||1.07||1.09||9.06||9.75||0.04||1.13||96|
|American Century Equity Income Inv||TWEIX||US Fund Large Value||8.82||0.78||1.18||0.94||9.06||8.75||0.07||1.01||93|
Source: Morningstar Direct
Many funds like those we have highlighted left investors with so little excess return after fees that it’s too difficult to predict whether they can repeat the meager outperformance they delivered.
Given that the average expense ratio of the funds in the study was 0.99% and outperformance was so scarce, there is a case to be made that large cap stock fund fees should be cut by more than 50%, even among those funds that have added some value.