• / Free eNewsletters & Magazine
  • / My Account
Home>Research & Insights>Investment Insights>For Passive Funds, a Stronger Link Between Fees and Performance

Related Content

  1. Videos
  2. Articles
  1. Our Picks for Global ETF Exposure

    Low-volatility strategies look attractive for developed-markets exposure today, says Morningstar's Sam Lee.

  2. Top Picks From Morningstar's Strategists

    Morningstar investment experts Russ Kinnel, Matt Coffina, Josh Peters, and Sam Lee answer viewer questions about the current market and the best opportunities in stocks , funds, and ETFs today.

  3. Session 3: Best Investment Ideas Roundtable

    A panel of Morningstar equity, mutual fund , and ETF experts detail several individual investment opportunities and sensible investing strategies for income and growth in today's tough market.

  4. Become a Better Index Investor

    Roundtable Report: Experts dig into the ETF versus index fund debate, active and passive strategies, fixed-income benchmarks, factor investing, and much more.

For Passive Funds, a Stronger Link Between Fees and Performance

When it comes to fund performance, you don't always get what you pay for.

Michael Rawson, CFA, 01/28/2015

When shopping for products of unknown quality, price forms a cue that shoppers can use to differentiate products. It is often a safe assumption that a higher-priced product offers better performance than a lower-priced product. For instance, the Porsche 911 lists for $93,000 while the Chevy Malibu will set you back $20,000. But this is not always the case, particularly with fund investing. Unlike the Porsche, there is no cachet from buying a high-priced fund. Still, price can be useful when predicting results--though not in the way fund companies would like.

Morningstar's Analyst Rating for funds is based on five pillars: People, Parent, Process, Performance, and Price. The first three of these pillars are somewhat qualitative, while Performance and Price are much more quantitative. Price is the most tangible, both in terms of the impact of price on fund performance and comparability across funds. On average, we find that the higher the price of a fund, the worse its performance tends to be, and the link between fees and performance is stronger for passive funds. 

The chart below illustrates the relationship between price and performance among U.S. equity funds. It shows the average alpha (excess returns after adjusting for risk relative to the category benchmark) for all funds grouped into five quintiles by expense ratio. The y-axis shows the average alpha and the position on the x-axis indicates the average expense ratio for the group. We included all U.S. equity funds that existed five years ago and survived through today. Because some funds have performance-based fees, we used the 2009 annual report expense ratio rather than the expense ratio during the sample period. This also simulates the results of picking funds based on currently available information and examining future performance.



As the chart illustrates, there appears to be an inverse relationship between fees and performance. The lowest-fee quintile has an average expense ratio of 0.64% and an average alpha of negative 0.71% while the highest-fee quintile has an average expense ratio of 2.02% and an average excess return of negative 1.94%. However, grouping the funds into quintiles masks the tremendous variability in the relationship between fees and performance, which is better illustrated in the following graph. 


  

Here, the relationship appears much less precise. In fact, a regression of alpha on expense ratio has an R-squared of just 6%, suggesting that fees explain a small portion of the overall variability in fund performance. However, there are a few issues that may obfuscate this relationship. The chart above includes all U.S. equity funds, even though small-cap funds have higher expense ratios than large-cap funds. It also includes all available share classes despite the fact that low-cost institutional share classes must outperform high-cost retail share classes of the same fund. Also, the relationship between fees and performance might be different for active and passive funds. Because passive funds seek to match an index less fees, the relationship between fees and performance might be stronger among them. In contrast to passive funds, well-run active funds have a better chance of earning back their fees. 

In order to address these issues, we narrowed our focus to large-cap U.S. equity funds and removed multiple share classes of the same fund to get a cleaner read on the link between fees and strategy performance. We also grouped active and traditional broad passive funds separately and removed most niche index and strategic beta funds (index funds that make active bets in an attempt to outperform traditional indexes). The results are shown in the following chart.

Michael Rawson, CFA is an ETF Analyst with Morningstar.
blog comments powered by Disqus
Upcoming Events
Conferences
Webinars

©2014 Morningstar Advisor. All right reserved.