Is Using Active Investment Management a Fiduciary Breach? - Part Four
In prior posts we’ve examined claims that two criteria, scale or the size of a mutual fund complex’ assets under management and significant manager ownership of a fund, are indicators of likely outperformance versus a benchmark and a fund’s peer group. We tested each claim and found no better than a random correlation with actual results over multiple long-term periods of investment performance.
Now, we examine one claim both studies agree on: That low relative fees as measured by mutual fund expense ratio indicates a lower likelihood of underperforming. (See: American Funds Distributors' Capital Idea: Expect More from the Core; 2015 & Fidelity Leadership Series' video U.S. Large-Cap Equity: Can Simple Filters Help Investors Find Better-Performing Actively Managed Funds?; 2015.)
As explained in an earlier post in this series, our evaluation universe consists of 76 actively managed large cap domestic equity mutual funds as categorized by Morningstar. The absolute fee range for this universe is from 0.39% to 1.92%, a range of 153 basis points which we divided into deciles with a range of 15 basis points, e.g., decile 1 = 39-54 basis points, decile 2, 55-70 bps, etc. Of that universe, 23 (30%) outperformed the S&P 500 and the Russell 1000 in 7 or more of the 11 long periods (64%) evaluated through the end of 2015.
The good news for the low fee criterion is that all of the funds in that top-performing group were in the lowest 50% of the fee deciles. The not so good news is that in all but one of those deciles outperformance and low fees did not correlate more than 50%. That is, in the lowest decile for example, only 1/3 of the funds (3-of-9) of the original universe with low fees outperformed the indices in 2/3 or more of the periods measured. In other words, two-thirds of the lowest fee funds did not outperform at least 2/3 of the time. Not exactly a strong correlation!
In the next two lowest fee deciles the results were somewhat better: In the second decile, 7-of-15 (47%) outperformed. In the third, 9-of-17 (53%) outperformed. As fees increased, the number of funds outperforming dropped dramatically: 2-of-20 in the 4th decile and 2-of-8 in the 5th decile.
What then? Is the “low fee” criterion a marker for superior performance – or, at least, for less likelihood of underperformance? On the positive side, we can see that, as was noted above, of the 70% of funds in the original universe, none in the highest five fee deciles made it to our top-performing group. Additionally, also as noted, of the 23 funds in our top performers group, 19 (83%) fall into the three lowest fee deciles. So, maybe there is something here…
Or not. Of the original universe of 76 funds, 19 both were in the lowest three deciles and outperformed the indices in roughly 2/3 of the periods measured. However, there are 40 funds in the lowest 3 deciles. This means fewer than 50% (48% to be precise) of low fee funds were able to earn a grade of D- (64%) in our evaluation. Not, it seems to us, as reliable an indicator as we might like.
In our next and final post in this series, we’ll look at an even smaller subset of our original study universe that not only outperformed in the eleven periods we measured beginning in 1986, but has continued to outperform in more recent periods.
Maybe there will be some clues for us in this very small group? Here’s hoping!
Keep an eye out for Part Five in this series - arriving shortly.
Ed Lynch is founder and CEO of FPG. He has worked with ERISA-qualified plan sponsors and designated fiduciaries in most aspects of plan development and maintenance since the early 1980s. Ed founded FPG with the mission to be a leader in the field of employee benefits and the most trusted source of information and evaluation in the retirement plan industry.