Swedroe: Look Past Expense Ratios

July 11, 2018

The evidence is clear that investors are waking up to the fact that, while the past performance of actively managed mutual funds has no value as a predictor of future performance, expense ratios dolower-cost funds persistently outperform higher-cost ones in the same asset class.
That has led many to choose passive strategies, such as indexing, when implementing investment plans because passive funds tend to have lower expense ratios. Within the broad category of passive investment strategies, index funds and ETFs tend to have the lowest expenses.
Based on my experience, most investors tend to believe that all passively managed funds in the same asset class are virtual substitutes for one another (meaning they hold securities with the same risk/return characteristics). The result is that, when choosing the specific fund to use, their sole focus is on its expense ratio. That can be a mistake for a wide variety of reasons. The first is that expense ratios are not a mutual fund’s only expense.

The Whelk
You may never have heard of a whelk. However, this little ocean creature can ruin an oyster’s day. A whelk looks like a conch, only a bit smaller. It’s equipped with a tentacle that works like an auger. The little whelk will drill a very small hole in the top of an oyster’s shell. Through this very small hole, a whelk can devour an entire oyster, sucking it out little by little until the oyster is gone.

Mutual fund expenses are like little whelks doing damage to your portfolio. A fund’s expense ratio tends to get the most scrutiny, but because it does not reflect all of a fund’s expenses, it can at times be a misleading indicator. In addition to a fund’s expense ratio, investors should consider trading costs (which include commissions), bid-offer spreads and market impact costs, which can be a problem even for index funds. The reason is that, to avoid what is called tracking error, they are forced to trade when stocks enter and leave the index they are replicating and active managers can front-run that trading.

Other passively managed funds, such as structured portfolios from fund families such as AQR, Bridgeway and Dimensional Fund Advisors, pursue patient trading strategies to minimize trading costs—accepting what should be random tracking error against a benchmark as the price they pay for lowering trading costs. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR, Bridgeway and Dimensional funds in constructing client portfolios.)
Finally, there’s the opportunity to earn fees from securities lending. Some firms are more aggressive than others. The smallest stocks tend to earn the highest lending fees. The differences in securities-lending revenue from one small-cap fund to another can often be significant (in some cases as much as 20 to 30 basis points).

Exposure Matters
There’s another issue that many investors ignore: Passive funds in the same asset class can have very different exposures to common factors that historically have provided premiums, as the following table demonstrates. Data is from Morningstar as of April 30, 2018. As you can see, while all three are passively managed U.S. small value funds, because of how they define their eligible universes, they have very different exposures to the size and value factors.

  Expense Ratio (%) Market Capitalization Price-to-Earnings (P/E) Price-to-Book (P/B) Price-to-Cash Flow (P/CF)
Bridgeway Omni Small Value (BOSVX) 0.60 $0.8B 13.3 1.3 4.7
DFA US Small Value (DFSVX) 0.52 $1.7B 13.9 1.2 6.1
Vanguard Small Value Admiral Shares (VSIAX) 0.07 $3.6B 14.9 1.8 7.9

The stocks in DFSVX have less than half the market capitalization of the stocks in VSIAX, and the stocks in BOSVX have less than half the market capitalization of the stocks in DFSVX. And the evidence is that most of the size premium has been in the smallest stocks. In addition, DFSVX’s portfolio has lower prices relative to the three value metrics than VSIAX’s portfolio, and BOSVX’s portfolio generally has even lower valuations.

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