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By Russel Kinnel and Christine Benz | 10-12-2017 12:00 PM

Kinnel: 4 High-Cost Fund Duds

These funds are prime examples that costs are the best predictor of future performance.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. When Morningstar's analysts rate funds, high costs are usually a nonstarter. Joining me to discuss some high-cost funds that are duds is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: Russ, you brought a short list of funds that have high costs and have either Neutral or Negative ratings, but before we get into the specifics, let's discuss why you and certainly, the whole research team, believes that investors should really pay attention to expenses when they are selecting funds.

Kinnel: It's one of the things we've studied up and down in all sorts of ways, and we know that costs are the most dependable predictor of future performance--not past performance, not anything else--costs. It sometimes seems a little counterintuitive because people see those past returns and say, well, this fund did really well even despite having high costs in the past, so why should I worry about it in the future. But of course, the catch is, returns vary a lot and those costs are consistent. Things can change at the fund, the markets change, but a fund's current expense ratio is actually a very good predictor of its future expenses.

Even when you look at funds with good performance but high costs, their future performance is really dismal. It's just a high-risk bet. Of course, it could still work out, sometimes it does. It's just not a good idea, because investing is about putting the odds in your favor. Going with low-cost funds is making it a lot easier for you to pick a good fund.

Benz: One of the funds that you think illustrates well why investors should pay attention to costs is LoCorr Macro Strategies. This is a fund that has had some changes behind the scenes recently. It sounds like the analyst thinks that it might be better in the future, but you think that the high costs are just a huge headwind for it.

Kinnel: That's right. The good news is, costs have come down. The bad news is, they are still 2.3%, which is a pretty high fee. It's a little complicated like a lot of alts funds. What this fund does is it invests in other firms that invest in future strategies. In the past, it did total return swaps which meant the other firm would guarantee they would get the return that they would have generated after fees. And so, because it was done in a swap form that fee that the subadvisor was charging wasn't showing up in the expense ratio.

Since then, they have switched around so that the managers are just charging a straight fee and that's now reflected in the expense ratio. So, it's more open. It's easier to see what you're really paying and that actually has brought fees down. At the end of the day, 2.3% is a very high hurdle to overcome and that's a real challenge, especially given that a lot of investments today are pretty low-returning.

Benz: Well, that's the thing--and this area of alternative type investments has historically and continues to be a space where managers charge more for these types of strategies. Is that justified in your view?

Kinnel: Not really, because generally they are lower-returning strategies and then you put on all of those fees. You end up with a kind of disappointing return. To be sure, there's a lot of specialization. Sometimes there's limitations on how big the strategy can be run. And of course, there's lots of quantitative tools often put to work. There are some reasons for the fees to be where they are, but generally, it doesn't make sense to actually invest in those funds.

Benz: That's a Neutral-rated fund. Another Neutral-rated fund that has the headwind of high costs is Gotham Enhanced Return. The ticker is GENIX, 2.15% expense ratio. Let's talk about that one.

Kinnel: Right. This is a 170-70 fund.

Benz: What does that mean?

Kinnel: It means it's 170% long, 70% short. So, essentially, what it means is, your leveraged. You've got a lot of leverage. It's going to still give you essentially 100% exposure, but it's got a lot of leverage. At a 2.15% expense ratio, even though we like some of the components at the fund, run by a good manager with an understandable strategy, but again, that's just a high hurdle and it doesn't seem like a good bet at the current price.

Benz: Now, turning over to a couple of Negative-rated funds, let's start with Federated Prudent Bear. Let's discuss first what strategy is in play here, what it's trying to do and then get into why you think that people should avoid it.

Kinnel: The idea is to bet against stocks and have an investment that's going to make you money in a down market. In a way, that's not a bad idea. I can see where a person might want a small position in that as a hedge. It's difficult because bear markets are so hard to predict and of course, it means you are losing money and compounding those losses most years. It's been a long time since the last one. It's kind of hard to use therefore. Then on top of that the fund charges a 1.78% expense ratio. You figure most years you're losing money from the market and then you got 1.78% additional taking money out of your pocket. It's an awfully hard game to win at.

Benz: I guess, a follow-up question for you Russ is, should people mess around with these types of bear funds, or is my high-quality fixed-income exposure may be enough to protect me against some sort of downturn in equities? I guess, it depends on how large my high-quality fixed-income exposure is.

Kinnel: For sure. I think high-quality fixed income is a good way to go, because it has low correlation with the equity markets. Often it even goes up when equities are selling off. I think for the most part boring old cash or short-term high-quality bonds are a much better hedge. For sure, they are not going to make you a lot of money, but they are easy to understand, they are low cost, and of course, they also serve the purpose of being there for you when you have an emergency or some other need you didn't expect. Obviously, a bear market fund is the last thing you would depend upon for an emergency. So, I think, for the most part, the simplicity of cash or something like cash is a much better deal for most investors.

Benz: Let's take a look at the last fund. It's AIG Flexible Credit. This is a bond fund--and before we get into the specifics of this fund, let's talk about why high costs and bonds is a terrible marriage.

Kinnel: Expenses are subtracted from yield, so, if you have a bond portfolio yielding 3% and a fund charging 1%, now you've cut your yield by a third and probably your return by a third as well, because returns and yields are fairly closely linked in the fixed-income world. The fixed-income world we are in today is a really low-yield environment. A lot of the best fixed-income funds charge between 40 and 70 basis points. You can get index funds for even less. When you see a high-cost bond fund, it's maybe even a bigger red flag than a high-cost equity fund.

Benz: And that yield, if its yield is competitive with its peers despite the high costs, that can be a signal that there's some risk-taking going on behind the scenes.

Kinnel: Right. This is a fund that has a mix of high-yield and bank loans, two higher-yielding areas. You're still going to get some yield. But when you think in that 1.43% expense ratio, that's a really high price. There's some very good high-yield and bank-loan funds for way less. This is one of the highest-cost bond funds we cover. I think, again, it's not necessarily that the manger or the strategy are so bad, it's just they've got such a high bar to overcome, it's really hard to make a case for a fund like that.

Benz: OK, Russ. Great discussion of the importance of keeping an eye on costs. Thanks so much for being here.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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