The price-quality relationship presents a complex question for consumer choices. On one hand, higher-priced products often deliver more features or embody higher quality, like smartphones with larger screens and more storage, or home goods with a higher standard of craftsmanship. On the other hand, price differentiation doesn’t always reflect product differentiation. A consumer may believe that an expensive car is somehow better, even if it offers similar performance, size, safety, and style as its less expensive counterpart.
The same question applies to investors in their role as consumers of fund products. In regard to passive funds, Morningstar’s behavioral science team has conducted experiments showing that consumers sometimes allocate to more-expensive options of funds that track the same index.
For this research, we posed the same price-quality question to active mutual funds: What do you receive when you pay more?
Below, we break down the key findings of the study, “ What Are You Paying For? Relationships Between Fund Expenses and Fund Characteristics.”
A closer look at active mutual funds
Active mutual funds seek to generate risk-adjusted outperformance against their benchmarks. They might do so by engaging a better investing process (for example, one that prioritizes aspects like factor tilts, risk management, and strategy execution) and higher-quality people (with features such as longer manager tenure and team experience). For this research, we sorted fund fees by their corresponding Morningstar categories and examined how these factors related to their relative positioning by quintiles.
First, we found that more-expensive funds are generally older and smaller. However, after controlling for fund size, we saw that lower-average manager tenure/fund-age ratios tended to correlate with higher expense ratios (as depicted on the chart below). This suggests that investors are not necessarily capturing long-run managerial experience by paying for pricier funds .
Next, we examined the behavior of active funds’ portfolios. Our research showed that the more-expensive funds in U.S. and international equity tend to have higher portfolio turnover, fewer overall holdings, and more concentration in their top 10 holdings. In fact, as the chart below shows, the most expensive quintile of funds is less diversified by number of holdings than the lowest cost quintile in every other asset class.
We further found insignificant differences in factor exposures—size, value, profitability, leverage, duration—across the fee spectrum.
But the most puzzling relationship this research uncovered was that between price and performance. In both U.S. and international equities, returns and alphas of active mutual funds in the most expensive quintile lag those that fall within the least expensive quintile (as shown on the chart below). This negative relationship persists even after controlling for fund net assets.
3 key takeaways for advisors
While average mutual fund fees have continued to drop over time, the fee differences between the most expensive and least expensive quintiles of funds have remained near constant. Though significant price differentiation persists, our research suggests that this does not generally reflect quality differentiation. There are a few ways financial advisors might craft strategies, based on this information:
- Assess the appropriate degree of risk and activeness for your clients. More expensive funds had more concentrated portfolios, in addition to a higher portfolio turnover.
- Analyze funds by their factor weightings. Our research showed that factor weighting can be the most indicative aspect of funds, since the expensive funds’ portfolio exposures did not significantly vary according to value, profitability, financial leverage, or duration.
- Consider taxable and municipal bond funds. Though pricier U.S. equity and international equity funds have a negative relationship between performance and fee levels, taxable and municipal bond funds indicate areas where outperformance may be purchasable.
These results indicate that investors should be particularly judicious about the value they receive for the fees they pay—in this case, higher price does not always represent higher quality.