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.

Using the regression tool available at Portfolio Visualizer enables us to see the factor loadings of the three funds (which shows how much exposure each has to the size and value factors). Data is from September 2011 (inception of BOSVX) through April 2018.

Fund Size Value
BOSVX 0.90 0.68
DFSVX 0.82 0.54
VSIAX 0.68 0.28

The table demonstrates that the three funds have very different exposures to these factors. Thus, investors should not just consider a fund’s expense ratio. Instead, investors should consider a fund’s cost relative to the factor exposure it provides. In other words, they should look at cost per unit of risk and return. Differences in factor loadings and fund construction and trading rules are why, while my firm has all three small value funds on its approved list, our recommended fund is BOSVX (despite its higher expenses).

Let’s look at some other examples of where a sole focus on expense ratios can create false impressions, and perhaps lead to the wrong conclusions.

Thanks to the SEC’s introduction of interval funds (which generally provide limited liquidity of 5 percent per quarter), investors now have access to unique sources of risk and return that used to be the exclusive domain of university endowments and hedge funds. Among them are alternative lending and reinsurance.

Alternative Lending
Alternative lending refers to investment in consumer, small business and student loans. Investors currently can access two publicly available funds to gain exposure to this asset class: the Stone Ridge Alternative Lending Risk Premium Fund (LENDX) and RiverNorth Marketplace Lending (RMPLX).

LENDX’s total cost, including the management fee and all other expenses, is 1.94 percent while RMPLX appears to be much cheaper at 1.50 percent. However, the reality is actually quite different. While both funds employ a small amount of leverage (about 28 percent of total assets), LENDX’s expense ratio only applies to the unleveraged assets while RMPLX’s fee applies to all assets. Once we account for the fact that investors in LENDX are paying fees on $100 of assets even though the fund has about $139 of assets ($39 is about 28 percent of $139) invested, versus investors in RMPLX, who are paying fees on the full $139 of assets, we find that investors in LENDX are incurring lower expenses. So, while investors in LENDX are paying $1.94 for every $100 invested, investors in RMPLX are paying about $2.09 ($1.50 x 1.39).

The story likely does not end there. As of June 2018, LENDX had about $3.4 billion in assets under management. RiverNorth’s fund had assets of about $300 million. It is not hard to imagine that Stone Ridge, with its much larger amount of assets, is able to negotiate better terms than RiverNorth when it buys loans. That could mean, for example, lower servicing fees charged by the originating platforms from which the two funds buy loans. It can also provide advantages in negotiations to buy pools of existing loans, and when participating in the securitization of loans. In addition, given its larger scale, it seems likely that Stone Ridge could negotiate lower borrowing costs on the leverage it uses. Such advantages could swamp a difference in expense ratios.

The same is true in the reinsurance marketplace, where Stone Ridge’s Reinsurance Risk Premium Interval Fund (SRRIX) is the largest public fund, with about $6 billion of assets. Scale should allow for a stronger negotiating position when buying quota shares from reinsurance companies. The ceding reinsurer doesn’t pass on 100 percent of the premiums it is paid, instead keeping a percentage to cover origination costs, which Stone Ridge, or another buyer, doesn’t incur. A larger player might be able to negotiate a higher percentage of the premium.
In addition, a larger player, one who acts as a long-term strategic partner and a provider of capital when it is needed the most (such as after major losses from hurricanes, as occurred in 2017), might have opportunities to provide capital at attractive terms when other players might not. (In the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends Stone Ridge funds in constructing client portfolios.)

A focus on keeping investment costs low is certainly a part of the winning strategy. However, I hope you now see that the exclusive use of that metric is a mistake. Investors need to be careful to consider all of the factors that affect the risks and expected returns of the funds in which they invest. And those factors often go well beyond the expense ratio. Drilling down into areas such as the ones we have discussed is how a good advisory firm can add great value through proper due diligence. It’s a very important part of the long process the investment policy committee at Buckingham goes through before we approve and/or recommend a fund for investment.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.



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