A Land Where High Fees Reign Supreme

Morningstar and other researchers have consistently found that expense ratios are one of the few data points predictive of future mutual fund performance, and investors have increasingly gotten that message, with greater asset flows going to the cheapest funds (as you can see here). Yet, when it comes to investing in alternative mutual funds, it seems that investors forgot to read the memo. 

Over the past three years, alternatives were the lone broad Morningstar Category where investors seemed to favor higher-cost funds over lower-cost funds. From 2011 to 2013, only 36% of the net $58 billion that has flowed into alternative mutual funds has gone to funds in the cheapest quintile. Across all mutual fund categories, 121% of the net $432 billion of inflows has gone to funds in the cheapest quintile over the same time period. The figure is greater than 100% because as money was coming into cheap funds, it was leaving more-expensive funds. 

Part of the reason for the meager flows into cheap funds is that investors appear to be performance chasing, paying less attention to fees. The performance chasing may be exacerbated by the lack of alternative funds with significant track records. The recent stampede into Bronze-rated  MainStay Marketfield (MFLDX), which has swallowed up one fourth of the $58 billion of net inflows since 2011, is a good example of money going after good returns. The $18 billion fund isn’t cutting investors any bargains. It has an expense ratio of 1.52% for its institutional share class, which falls right in the middle of similarly distributed alternative funds, despite its being the group's largest. The flows have had a big impact on the average fees investors pay in the category. The asset-weighted expense ratio of the long-short equity category jumped to 1.38% in 2013 from 1.24% in 2012. The asset-weighted expense ratio in every other alternative category either fell or stayed flat. Asset-weighted expense ratios count bigger funds proportionally more than smaller ones. To be fair, MainStay Marketfield’s fees have dropped from 1.81% in 2009, but, given how high they started, they still have a long way to go before they'll look cheap relative to peers.

Why High Fees Matter
If history is any guide, alternative funds that are cheap are likely to outperform more-expensive funds going forward. It’s not hard to understand why. Every dollar you don’t pay in fees is an extra dollar added to your total return. What's important to remember is that investors have more control over the fees they pay than virtually any other component of performance.

One way that Morningstar gauges the predictive power of fees is by success rate, a measure of which funds both survived and outperformed their categories over a given period. We prefer success rate instead of just looking at trailing returns because it eliminates survivorship bias. It is important to take into account funds that are liquidated as high-cost funds are more likely to be liquidated than low-cost funds.

As Morningstar's Russ Kinnel demonstrated recently, in the broad U.S. equity group, funds with expense ratios in the lowest quintile had a 55.98% success rate from 2008 to 2013, the next-cheapest tier of funds had a success rate of 45.69%, funds with average expenses had a 38.84% success rate, while the most-expensive quintile of funds had a success rate of just 23.57%. The higher the fees, the less likely funds were to survive and outperform. The results were similar in the sector-equity, international-equity, taxable-bond, and municipal-bond groups.

Because so many alternative mutual funds have emerged in just the past few years (as of July 31, 268 of 461 alternative funds lacked five-year track records), it is difficult to do a meaningful analysis of performance and survivorship. We'll be keeping a close eye on the predictive power of fees in the alternative categories, like long-short equity and multialternative, as the more recently launched funds develop track records.

Although some alternative funds will look cheap relative to others in the broad alternatives group, alternatives look pricey relative to mutual funds as a whole. For example, to qualify for the cheapest quintile among alternatives, a fund has to charge less than 1.29%. That price tag is nevertheless expensive compared with traditional categories. An expense ratio of more than 1.25% in the large-cap category, by contrast, would be above average compared with its peers. 

Room for Change
There is some good news for alternative fund investors. Overall, alternative fund fees have been falling. In 2013, the asset-weighted expense ratio of alternative funds was 1.36%, down from 1.41% in 2011 (overall, asset-weighted expense ratios fell to 0.71%, from 0.75%). Alternative fund expenses are actually higher overall though because annual net expense ratios don’t include the extra management and performance fees imbedded in some managed-futures strategies or the acquired fund fees found in about a third of multialternative funds.

A handful of alternative funds have been more aggressive cutting fees as assets have grown in size. Neutral-rated  JHancock Global Absolute Return Strategies (JHAIX), the largest fund in the multialternative category, extended its management fee breakpoints in July to account for its ballooning assets. It now has more than $5.5 billion in assets, up from less than $1 billion in 2012. As a result, fees are now a below-average 1.42%, down from 1.59% in 2012. Neutral-rated  Neuberger Berman Absolute Return Multi-Manager (NABIX) cut its fees from an above-average 2.45% in 2012, when it launched with around $10 million in assets, to an average 2.01% last year as assets topped $1.5 billion.

Some in the industry also make the case that alternative mutual funds already can be considered cheap when compared with hedge funds, which charge management and performance fees. Indeed, it is an old saw (or myth) of the hedge fund world that you get what you pay for, and this may be another reason that assets have gone to more-expensive alternative funds. However, when it comes to picking mutual funds, higher costs don’t necessarily equate to higher quality. A handful of the Morningstar Medalists in the alternative category, such as Silver-rated  Gateway (GATEX) (0.94% expense ratio), Silver-rated  AQR Diversified Arbitrage (ADAIX) (1.20%), and Silver-rated  Merger Fund (MERFX) (1.24%), have proved that investors can find good alternative funds at relatively cheap prices.  

Vanguard, best known for its focus on low costs, has shown just how cheap alternatives can get. Because of its unique mutual ownership structure, funds are offered at the price they cost to run. Bronze-rated  Vanguard Market Neutral (VMNFX) charges just 0.25%, far less than the 1.87% category norm.

Over time, it's likely that more investors will see the light and turn their eyes (and wallets) toward more-affordable alternative options.