Shopping for Funds: Is Cheaper Really Better?

Shopping for Funds: Is Cheaper Really Better?

A recent CFA Institute article poses the question: “Why, on Wall Street of all places, would the best managers charge less?”

The article cites a recent Morningstar study showing that in 2019, “a whopping 93% of net new money into active strategies flowed into the least costly 10% of funds. Clearly, investors have become allergic to paying above-average fees.”

That said, however, the article warns that despite the seemingly inverse relationship between a fund’s expense ratio and its performance, “it’s a fallacy to use that fact as a basis to favor low-cost funds.” It explains that the best managers don’t offer discounts to investors, but rather that the “market is swamped by a large number of strategies that fail to add value in excess of their costs.”

So, what’s an investor to do? According to the article, if they are able to determine the skill level of an active, then expense ratios shouldn’t matter at all: “Fees only have meaning in comparison to returns.” On the other hand, if discerning skill levels is impossible, investors should “simply buy a passive index, because even the cheapest unskilled manager isn’t worth paying for when benchmark exposure comes practically free.”

If the heightened focus on fees continues, the article notes, then “high-ability managers will exit the market over time, and their employers will replace them with lower-cost stand-ins” leading to a situation where “only the ‘lemons’ remain.” In such an environment, it says, “active funds won’t be worth buying at any price.”

The article concludes, “Investors should be agnostic to absolute fees, and instead rank investment options on their value added net of costs. If they aren’t equipped to do that accurately, they’ll be better served by avoiding the risks and expense of active management in favor of low-cost indexes.”