Christine Benz: Hi. I'm Christine Benz for Morningstar.com.
Expense ratios are one of the key inputs in our Analyst Rating system. Joining me to discuss some Medalists funds that recently lowered their expense ratios is Russ Kinnel, director of fund research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Good to be here.
Benz: Russ, let's quickly review why we stay so attuned to costs. What do you see when you look at the data on the role of costs in terms of predicting future performance of funds?
Kinnel: It can sometimes seem like where we are pinching pennies, and it doesn't matter that much--I'm talking about 14 basis points here, 2 basis points there--but in fact it's really the best predictor of fund performance. The reason is that it's a consistent thing. It's there every year. Manager strategies go in and out of fashion, funds can get bloated, lots of things go on--but expenses are there every year.
Today's expenses are pretty good predictors of future expenses, and over a long period of time, those fees can really add up and really have an impact. So one of the simpler and easier ways you can get to your goals is just focus on fees, get low-cost funds. As Jack Bogle likes to say, you get what you don't pay for.
Benz: When you look at the trends in expense ratios, and I know you periodically study this, what do you see in terms of fund expense ratios? Are they going up on average or are they going down?
Kinnel: They are going down. They have really been steadily coming down, not dramatically, but steadily for most of the last 10 or 15 years. After a year like 2013, where the stock market surged, U.S. stocks anyway, over 30%, you get a bigger drop in fees because fees are often geared off of assets. So growth in assets mean a drop in fees.
Now, in the bond fund world, assets are about the same as they were a year ago, so you're not going to see a big change there. But whenever you have a big rally in any asset class, you're going to see some drop in fees.
Benz: Do you think that this ongoing investor preference for index products and ETFs is also a catalyst for expense ratio cuts?
Kinnel: A little bit. I think particularly in index mutual funds. Open-end index funds obviously see themselves as competitors with ETFs, and so we've seen firms like Schwab and Fidelity and Vanguard be more aggressive with their fee cuts there.
In the actively managed space, it doesn't seem like they are that motivated yet, though. If ETFs keep taking their market share, maybe they will be a little more motivated.
Benz: One would think.
Another factor I know that does contribute to expense ratio changes is the role of performance fees. Let's talk about what performance fees are, how widespread they are, and also how they affect fund expense ratios.
Kinnel: Performance fees act as a pendulum. In other words, typically a fund can incent themselves by saying, if we beat a benchmark by a certain amount over, say, a three-year period, then we will increase our management fees. So you might see a fund … have a base fee of 40 basis points, but then they can get another 20 basis points if they beat the index by the maximum amount.
On the other hand, though, it has to swing the other way, so if they are lagging by a similar amount, they would have to cut their management fee by 20 basis points. It has to go both ways, and it has to be after expenses. Having great returns before expenses doesn't get you anywhere on that. So, it's kind of a good way of aligning incentives with management.
The biggest firms to do that are Fidelity and Janus, at least in terms of the size. So you'll see that a lot with their funds. Vanguard's subadvisors, the active managers, sometimes have a performance fee, too, though it's much smaller. So it might add a basis point or two here or there, so [you see] much, much smaller swings. Fidelity and Janus are the biggest, and a lot of other fund companies do not have performance fees at all.
Benz: So not a widespread practice, but some of the big players in fact have them.
Kinnel: That's right.
Benz: I want to look at some of the funds that have had fairly sizable expense ratio changes, and they're funds that we like. Let's start with Fidelity Large Cap Stock; that one recently got a bump up to Silver and an expense ratio cut.
Kinnel: Its expense ratio fell 14 basis points to 84 basis points, which is a pretty good price for a large-cap actively managed fund. Matt Fruhan has run it since 2005, with kind of a bit of growth, but also kind of an attempt to catch cycles at the right time, and he has done a really good job, with very strong returns. So we rate it Silver, and now it's actually a pretty cheap fund, so very attractive overall.
Benz: So what was the issue here? Is it that assets have grown? What was the catalyst?
Kinnel: Assets have started to grow, and the fund has gotten a little cheaper; however, performance has been so strong, we may see the performance fee kick the other way later, but I think Fidelity's actively managed funds tend to be pretty reasonably priced. I wouldn't call them super cheap. Vanguard or Dodge & Cox have them beat on fees, but they're still pretty reasonable. So when you see a fee cut like that, it's still pretty attractive.
Benz: A follow-up question on that fund: As we've discussed, there has been a strong investor preference for indexing, and there are some data to suggest that maybe that's not an unreasonable thing to do in the large-cap space. Why would one consider an actively managed product like the Fidelity Large Cap Stock Fund, which is a large-cap blend fund?
Kinnel: The fund has significantly outperformed the S&P 500 over the last five years, and modestly over Fruhan's tenure, so obviously, if you are doing it, it's because you want to beat the index. But of course, as with any active fund, there is also the chance that you'll lag the index significantly. I don't think--if you're closely indexed--I don't think that's such a bad result, but you're certainly taking that chance.
About a third of active managers in a typical year will outperform the index. So the question is really, do you think you can identify the right factors in selecting an active manager who will succeed in the future?
One good thing about this fund versus some other Fidelity funds is, it still has a modest asset base. I think it's a good fund. We like index funds, too, so we are not saying this is the only way to go; I own both in my own portfolios, too.
Benz: Another fund that you highlighted in your recent report--a fund we like that did have a big expense ratio cut--is a lesser-known name, RiverPark/Wedgewood Fund. Let's talk about it, what its overall strategy is, and what sort of expense ratio change we've seen recently.
Kinnel: David Rolfe is the manager. He has only got about four to five years at this fund, but he actually has a much longer track record, which is what got us to a Silver rating. The fund record alone isn't enough.
He is a focused manager, kind of a growth-at-a-reasonable price strategy, and for him it's all about conviction. He really has to believe in the company and the management before he is going to invest. But if he does, he will invest a significant sum.
So it's a focused fund, still fairly new, and it's not uncommon in newer funds that start to gain assets that you'll see this bigger move down in expenses. In this case, it went from 1.25% to 1.14%. So 1.14%, for a large-cap fund, as I said before, that's not super cheap.
Benz: Not the cheapest. No.
Kinnel: What it's done is it's gone from a little above average to closer to average, so obviously, you have to have faith in the manager. He is running a modest amount in this fund and then some more in separate accounts, but it's still not a huge amount overall, and if you look at his track record, it's a very appealing risk-reward payoff over a number of years.
Benz: What is RiverPark and how do you and the team get comfortable with a lesser-known shop and maybe a smaller firm?
Kinnel: RiverPark is a small firm based out of Kansas City that has been doing separate accounts for a much longer time and more recently funds. We meet with management, and in fact he was just here last week. So we get to know them, we get to know their track record, we look to see if they're really executing what they say they're doing, and over time we will get more comfortable just as we will with a bigger firm. In a way, it's easier, because there are just a few players at an operation like RiverPark.
Benz: You mentioned a couple of times that the funds that we've highlighted here are not the cheapest of the cheap. If people want ultra-cheap funds, there is plenty to buy in terms of index funds and ETFs.
You noted that Vanguard, though, recently did cut the expense ratio on its Total International Stock Market Index by at least a couple of basis points, and now it is--and it was before--a very, very cheap fund.
Kinnel: That's right. Vanguard has cut the fund's fees from 16 basis points to 14 in the Admiral Share class. That fee cut is not as big as the ones I've mentioned, but I think it's worth mentioning, because, of course it's really, really cheap. Vanguard is more diligent than anyone I know of at keeping fund fees lower and lower. So if they make incremental gains over here, either because of asset growth or they find some other efficiency, it's going to go to lower the fees very, very quickly. So I think it's really worth highlighting.
If we really want to get cheap, look at a fund like this where, even at 16 basis points, Vanguard found a couple more basis points to shave. Now it's just 14 basis points, and when you think about a good core foreign holding, this is obviously just about the definition of it: very diversified and very low costs, very dependable.
Benz: Russ, thank you so much for being here.
Russ Kinnel: You're welcome.
Christine Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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