You Paid How Much to Hug the Benchmark?

You're probably familiar with the old expression "you get what you pay for." The idea is that if you don't spend much, you likely won't get much in return, and if you spend more you can expect more. 

The expression may hold true when buying cars or clothes. But in investing, it is often turned on its head. Not paying much, in fact, is one key to a fund outperforming its pricier rivals. That's because fund expenses are deducted from returns, so a fund that charges high fees takes a bigger bite out of returns than one charging low fees.

Fund investors typically are asked to pay higher fees for actively managed funds than for index funds. After all, active management requires greater research than a passively managed fund does. In fact, the average expense ratio among actively managed equity funds was 93 basis points in 2011, according to the Investment Company Institute, well above the 14 basis points charged by the average index equity fund.

The best active managers try to outperform their index benchmarks by looking different than those benchmarks. A manager might be overweight or underweight in different stocks or sectors in order to overcome his fund's higher costs and outperform the index. Last week we looked at some of these funds, homing in on large-blend funds that had differentiated themselves from the benchmark S&P 500 index during the past decade while earning recommendations from our analyst team. We did this by ranking the funds by their R-squared rating, which measures the level of correlation between a fund and its benchmark, in this case the S&P 500.

Are You Overpaying? 
This week we call out large-cap funds that have done the opposite, hugging the benchmark S&P 500 during the past decade while charging above-category average fees. For investors in these funds, all of which charge at least 120 basis points, a serious reappraisal may be in order.

In nearly all cases managers of these high-cost benchmark-hugging funds had a hard time overcoming their funds' cost hurdles. Nine out of the 10 funds on the list lagged the S&P 500 during the trailing three-year period ended May 13 (First Investors Growth & Income (FGINX) matched the index's performance). Most, though not all, lagged during longer time periods, as well. One notable exception was Gabelli Equity Income AAA (GABEX), a no-load fund that managed to beat the index during the trailing five- and 10-year time periods but that charges a 1.40% annual fee, higher than the category average.

The table below was put together using Morningstar's Direct platform, which is aimed at institutional investors. But you can perform due diligence on your own large-cap fund holdings on Morningstar.com by checking the fees you are paying along with the fund's long-term R-Squared and performance. You'll find R-Squared data for funds for various time periods by clicking on a fund's Ratings & Risk tab on Morningstar.com and looking in the MPT Statistics section.

If a fund you own shows a high degree of correlation with its benchmark (say, 95% or greater), delivers mediocre performance or worse, and charges high fees, you might want to seriously consider switching to a lower-priced actively managed fund that doesn't hug the benchmark, or to a low-cost index fund. That way you stand a better chance of getting more by paying less.  

A High Cost for a Benchmark
	Star Rating	Expense Ratio	10-Year R-Squared	5-Year R-Squared	3-Year R-Squared
Prudential Large Cap Core Eq (PTMAX)		1.20	99.06	99.26	99.55
Principal SAM Strategic Gr (SACAX)		1.48	97.19	98.10	97.93
JPMorgan Investor Growth (ONGAX)		1.49	96.85	97.41	97.48
Gabelli Equity Income AAA (GABEX)		1.40	96.84	98.59	97.55
Wilshire Lg Company Val (DTLVX)		1.36	96.62	97.62	97.90
Target Growth Allocation		1.55	96.34	98.39	98.04
First Investors Equity Income		1.29	96.28	97.81	97.70
First Investors Growth & Inc (FGINX)		1.23	96.25	97.39	98.14
Wells Fargo Adv WB Equity		2.32	96.21	96.77	96.39
ALPS/WMC Disciplined Value		1.40	96.09	97.51	97.88
Data as of 05-13-13