Fee Study Reaffirms Bogle Fund Research on Fund Costs (Again)

August 13, 2004

A revisit of fund fees shows a devastating analysis the the direct (inverse) relation between fees and performance.

With most market experts endlessly touting the next hot sector or mutual fund, Vanguard founder John Bogle's mantra is perhaps best summed up in two words - costs matter.

Many index investors are familiar with Bogle's research, some of it decades old now, that shows fund managers in both the equity and bond universe have an extremely difficult time keeping pace with benchmark indexes.

Recent investigation by investment research firm Standard & Poor's reaffirms that investors should pay close attention to costs when shopping for mutual funds.In a study that included over 17,000 stock funds from S&P's database, funds charging smaller than average fees to investors outperformed their more expensive peers in eight of the nine investment 'style boxes' over a one-, three-, five-, and ten-year annualized basis.The only category where more expensive funds won was in mid-cap blend, whose five- and ten-year annualized returns came out ahead of their less expensive counterparts.

'Few, if any, fund characteristics can be linked to performance more so than the level of expenses,' said Phil Edwards, S&P's managing director.'As Standard & Poor's research has shown for the second consecutive year, high levels of expenses can significantly eat away at a fund's overall performance.It is important for both investors and financial advisors to keep fund expenses in the forefront of their analysis when assembling a portfolio.'

Although S&P used a relatively straightforward methodology in the study, the results put the effect of higher expense ratios in a stark light.First, S&P calculated the average expense ratios for every fund style box, and simply sorted the funds into two categories - those with an expense ratio below the average of their peers and those with an expense ratio that was higher.

The average annualized return for each of the two categories was compared over a one-, three-, five-, and ten-year performance period.S&P found that in most cases performance did not justify a higher expense ratio in a mutual fund.

'Given the results of this study, it is clear that expenses continue to play a significant role in the overall return of a mutual fund,' Edwards said.'Since a fund's expenses are typically stated in percentage terms, it is often difficult for investors to understand the cost implications. Standard & Poor's believes that investors would be better served by stating expenses in dollar and cents terms.'

 

Style category

1-year return (%)

3-year return (%)

5-year return

Large-Cap Growth

Above average ER

14.75

-6.97

-5.04

Below average ER

16.07

-5.32

-3.37

Large-Cap Blend

Above average ER

14.93

-3.89

-2.50

Below average ER

17.27

-2.51

-1.26

Large-Cap Value

Above average ER

17.74

-1.53

0.84

Below average ER

18.79

0.01

1.81

Mid-Cap Growth

Above average ER

21.03

-4.45

0.69

Below average ER

22.83

-3.14

2.39

Mid-Cap Blend

Above average ER

23.35

3.38

8.37

Below average ER

25.47

4.93

7.99

Mid-Cap Value

Above average ER

25.94

6.89

8.01

Below average ER

26.18

7.29

9.83

Small-Cap Growth

Above average ER

26.04

-2.58

2.88

Below average ER

27.50

-0.77

5.65

Small-Cap Blend

Above average ER

30.67

5.60

7.83

Below average ER

30.01

7.33

9.79

Small-Cap Value

Above average ER

30.73

9.39

12.20

Below average ER

31.78

11.22

13.33

Source: S&P, data as of: 5/31/04

Although actively managed funds must overcome the expense hurdle to beat cheaper funds, including index funds and ETFs, they also saddle investors with higher transaction costs and taxes.

On top of that, a recent Wall Street Journal article highlighted the poor stock-picking skills of some of the largest actively managed funds.In a report prepared for the WSJ, Chicago-based fund tracker Morningstar took the largest stock funds in 1999 and calculated the returns through June of 2004.Then, those returns were compared against the theoretical performance of the funds if they had stood pat and made no changes to the portfolio over the period.

The results were a chilling indictment of Wall Street's stock picking ability - Morningstar found that 11 of the 15 largest actively managed funds would have performed better if they had simply sat on their hands over the 4.5 year period.

John Spence is a contributing editor of IndexUniverse.com. Check out his musings on the ETF industry each Monday at CBSMarketWatch.com. If you have comments or story ideas for John or any of our writers, please contact us at [email protected].

 

 

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