The Academic Argument for Expensive Mutual Funds

Repent, Sinners! Last week, I encountered what I never expected to see: an academic article that extols the merits of high-cost mutual funds.

Cheaper is Not Better: On the Superior Performance of High-Fee Mutual Funds--henceforth to be known as CNB--attempts to throw conventional wisdom on its head. The authors, Jinfei Sheng of UC Irvine, Mikhail Simutin of Toronto, and Terry Zhang of British Columbia, claim that, when properly evaluated, higher-cost U.S. equity funds do not perform badly. "We show that after controlling for exposures .... high-fee funds significantly outperform low-fee funds before expenses." Well, that's a first! Let's see how the authors arrived at that conclusion.

For Starters The first thing to note is that CNB evaluates only U.S. equity funds. The approach of studying U.S. stock funds and then extending that finding to cover all varieties of fund is common. For data reasons, domestic-equity funds are easiest to analyze. But that tactic cannot be used in this case, because the paper's methodologies apply only to U.S. equities. Therefore, CNB's findings do not apply bond, allocation, or international-stock funds.

In essence, CNB claims that those who study U.S. equity funds botch the job. Researchers think that separating funds that invest in large companies from those than invest in small, and funds that invest in pricier firms (growth stocks) from those that pursue bargains (value stocks), permits like-versus-like comparisons. They believe that, in doing so, they correct for the important differences. CNB's authors say not; in their view, the work is only half done.

Fama and French This idea that U.S. stocks can be sorted by size and price predates Morningstar's equity Style Box. It was popularized in the 1980s by institutional investment consultants, and ratified in 1992 by the publication of "The Cross-Section of Expected Returns," by future Nobel Laureate Eugene Fama and his colleague Ken French. That highly influential article supported the current industry practices. What mattered when modeling the behavior of U.S. stock prices was: 1) the market's overall return, 2) the company's size, and 3) its price/book ratio.

This scheme became known as the Fama & French "three-factor model." It reigned for more than 20 years, albeit sometimes modified by the addition of a fourth factor, momentum. Then, earlier this decade, Fama & French suggested that their three-factor model be expanded to five. They eschewed momentum ("not invented here" being an academic as well as corporate practice), instead selecting two new factors: profitability and investment.

Profitability refers to the level of a company’s operating profits. Investment measures the extent to which firms reinvest their earnings into their businesses, as opposed to, say, paying dividends or repurchasing shares. Thus, stocks with high profitability and low investment ratios are those that generate unusually good profits, but which disburse most of those earnings, while stocks with low profitability and high investment are the opposite.

CNB's Contribution CNB innovates by testing U.S. equity funds with the new Fama & French five-factor model. The experiment worked; the authors found something. On the whole, expensive funds did not have average amounts of the profitability and investment factors. Rather, they fit the second of the two profiles mentioned in the previous paragraph: Their holdings have below-average profitability and above-average investment rates.

The authors think they know why: “High-fee funds tilt their portfolios to high-investment, low-profitability companies because estimating those companies’ intrinsic value is more difficult and requires greater skill. Funds that choose to invest in these companies must spend more resources on valuation, for example by hiring more talented managers, to justify the higher fees.”

That, friends, is what we researchers call a “guess.” They have no evidence for that hypothesis. I have scarcely more evidence for mine, which is that high-expense funds tend to be those that sell through costly distribution channels, and/or are sponsored by investment-management firms that believe in charging what the market will bear. Suffice to say that, when it comes to explaining the motivations of high-cost U.S. equity mutual fund managers, we are each telling stories.

Theory versus Practice What is indisputable, however, is that the investment approach adopted by the high-cost funds hasn't worked. Stocks from companies that have relatively low levels of profitability perform relatively poorly, as do those that invest more aggressively into their businesses. The combination, unsurprisingly, is worse yet. Reinvesting heavily into low-profitability enterprises reduces a company's stock price. Fancy that.

Now comes the payoff. Adjusted for the lower expected rate of their portfolio holdings, which are reduced by their exposure to low-profit, high-investment companies, expensive U.S. equity funds perform well. They have better returns than the Fama & French five-factor model would suggest. Collectively, they possess “alpha.” They are, as CNB states, “superior performers.”

But only in theory. In practice, because high-cost U.S. stock funds are hurt by both their extra expenses and their investment leanings, they have lower total returns than do cheaper funds. They have made more money for CNB’s five-factor alpha calculation, but less money for living, breathing shareholders. That won’t change, unless such high-cost funds break their 40-year habit and invest in companies with different characteristics, or low-profit, high-investment firms confound both logic and history by performing well. Neither possibility seems likely.

In summary, there’s no real-world justification for owning expensive funds. CNB’s definition of success does not match those of investors. What’s more, its conclusions, such as they are, hold only for U.S. equity funds.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.