Lower Fees, Far Greater Chance of Success for Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

A fund's costs are one of the key determinants of its success or failure. Joining me to discuss some recent research into that topic is Ben Johnson, director of global ETF research with Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me.

Benz: In a recent issue of Morningstar ETFInvestor you looked at the success rates of active funds relative to passive strategies. Let's discuss how you define success.

Johnson: Success has two underpinnings. First and foremost, in order to have been classified as "successful," an active fund has to have survived throughout the period. What we find is that, especially over longer periods, about half of the funds over the 10-year period that we studied across most categories didn't make it to the end of the 10-year period. So, survivorship is one element of success. Of course, that's fairly obvious.

The next element is, did that particular actively managed fund produce a level of performance that was better than a composite of the performance of its passive alternatives. Did it beat its passive peer group? Did an actively managed U.S. large-cap value fund beat a composite of index funds that occupy that same section of the Morningstar style box. Those that survived and thrived--and by thrived I mean beat that passive composite--were deemed successful.

Benz: When you ran the data through the end of 2014, what you saw was a pretty underwhelming picture for active funds, and this ran across categories?

Johnson: I think it depends on the timeframe in question. It depends on the category in question. But generally, the results were definitely underwhelming. Now, that varies over shorter time spans. Active managers in certain categories have fared better. But over the longest timeframe that we examined, going all the way back to 2004, what we saw was generally somewhat unimpressive.

Benz: You took another step and further subdivided the data. You looked at the lowest-cost quartile of active funds and compared them to that passive composite. You did the same with the highest-cost quartile of funds. What did you find there, and what do you think are the takeaways from that particular data?

Johnson: What we saw, in all cases, is that that lowest-cost quartile had a far greater chance of success relative to the highest-cost quartile. One of the chief hurdles that any active manager is facing is their fee. The lower that hurdle, the likelier they are to ultimately surmount that hurdle. And the higher that hurdle, the likelier they are to fall on their face, to fall short of that passive composite. We've shown this in other studies that we've done. Others who have done similar research in academia and outside have shown that fees are perhaps the only semi-reliable predictor of future success when it comes to fund selection.

<TRANSCRIPT>

Benz: Jack Bogle calls that the "cost matters" hypothesis. When you look at the choices that investors seem to be making, do they seem to be acknowledging that costs matter? Are they swapping into lower-cost investment options?

Johnson: The data show there certainly is that growing realization. Earlier this year Mike Rawson and I conducted our annual fee study. We looked at fees across the U.S. funds' landscape, looking at mutual funds, looking at ETFs. What we found is that over the course of the past decade, 90%-plus of all new investment inflows into U.S. funds have gone into funds that occupy the lowest-cost quintile. So, costs matter, which I would argue is not so much a hypothesis. It is a fact. And I think increasingly investors are aware of this. They are voting with their dollars, and they are placing more of those dollars into low-cost funds.

Benz: In your ETFInvestor article you looked at the full gamut of costs that investors pay--the direct fund costs as well as things like tax costs. Let's talk about tax costs in particular. Are ETFs the right answer for investors looking to control their tax costs?

Johnson: I think ETFs are an answer. There are multiple answers for investors who are looking to keep the drag that's associated with taxes under wraps. ETFs are one of them. Index mutual funds are another perfectly suitable answer. The commonality between those two is low turnover. When you're looking at broad-based index exposure, the run rate turnover of the total stock market index is 3% to 5% a year. That, in and of itself, is a very cost-efficient strategy.

ETFs, different from index mutual funds, have this additional layer in the in-kind creation and redemption mechanism. They can take low-tax-cost-basis securities out of their portfolio wholesale, hand them over to another party, and not realize any taxable capital gains. They have this added layer of protection against these tax frictions.

So, ETFs are an answer. They are not necessarily the only answer. Most of their tax efficiency springs forth from the fact that they are just index funds, but again they have this added layer against potential nasty tax implications.

Benz: And you won't necessarily have a tax advantage by buying an ETF in certain categories, like fixed income, for example?

Johnson: Fixed-income ETFs are inherently less tax efficient relative to, say, a broad U.S. equity ETF by virtue of the fact that there are bonds in that portfolio that are constantly maturing, and it would actually be more costly to try to liquidate those bonds prior to maturity than it would be simply to hold them to maturity and pass the tax implications on to investors.

I think it's also important to understand, too, that ETFs do not vaporize tax liabilities. You're still going to be on the hook for dividend taxes in the case of equity ETFs. In the case of fixed-income ETFs, you are still going to be receiving normal coupon payments, and you are still going to be taxed on any capital gains that you realize when you sell your ETF. So, ETFs are good for deferring tax liabilities. They do not magically vaporize any sort of tax liability.

Benz: Your overall message is, the more you manage all of these costs, the higher your take-home return is apt to be.

Johnson: Absolutely. If there is any known quantity, if there is any low-hanging fruit, it's managing costs--both the direct fund costs and the tax costs in particular. They are part of that basket of low-hanging fruit that investors can easily pick.

Benz: Ben, thank you so much for being here to share your insights.

Johnson: Thank you.

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