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[NEW YORK] HOW much a fund costs to run may seem inconsequential, especially now. With the backdrop of a "go big or go home" stock market that frightens many small investors but can enrich those who take a chance, how could several tenths of a percentage point in operating expenses, one way or the other, really matter?
Those tenths of a point are important, especially when a fund's return shrinks, financial advisers say. And these costs are one of the few components of portfolio performance that investors can consistently and reliably do something about.
"Expenses always matter," said Christine Benz, director of personal finance for Morningstar. "Fund buyers have no control over interest rates or the economy or how markets perform, but they do exert some control over investment-related fees."
The average total expense ratio, which encompasses management fees and operating expenses but not brokerage commissions and other trading costs, is 1.33 per cent of assets a year for domestic stock funds and 0.97 per cent for domestic bond funds, according to Morningstar.
The importance of exerting control over costs becomes clearer when they are compared to figures that mean more to investors than the mere ratio of expenses to assets. When considered as a percentage of fund returns, these expenses can seem alarmingly high, especially when they reduce income needed for retirement.
In an article last year in Financial Analysts Journal, William Sharpe, a Nobel laureate in economics, calculated that owners of the Vanguard Total Stock Market Index fund, a passively managed fund with annual expenses of 0.06 per cent, could "look forward to having the funds saved for their retirement provide 20 per cent more purchasing power" than owners of actively managed stock funds, with typical expenses of 1.12 per cent.
He acknowledged that some actively managed funds consistently outperformed the market. But he assumed, based on findings in numerous studies, that actively managed funds would collectively approximate market returns, minus costs.
"Whether one is investing a lump-sum amount or a series of periodic amounts, the arithmetic of investment expenses is compelling," he concluded. "Although a long-term investor may be able to find one or more high-cost managers who can beat an appropriate benchmark by an amount sufficient to more than offset the added costs," he added, managers with such acumen are extremely rare.
Recent research by the financial advice firm Gerstein Fisher concurs. The firm divided more than 2,000 actively managed stock funds into five equally sized groups from most to least expensive. It found that fewer of the funds with the highest costs, 15.7 per cent, beat their market benchmarks from 1998 to the middle of last year than those in any other group. The group with the most outperformers, 30.1 per cent, was not the cheapest, however, but the second cheapest.
A reasonable inference to draw from studies like this and Mr Sharpe's is that investors are better off in dirt-cheap index funds than actively managed ones. But investment advisers often contend that active managers can earn their keep in comparatively under-researched niches, such as smaller companies or emerging markets.
The Gerstein Fisher finding that the cheapest funds underperformed the next-to-cheapest group also suggests that the link between costs and returns is not so simple. Asked to take a stab at explaining that finding, Ms Benz noted that funds with more assets tend to have lower expenses because fixed costs are more widely dispersed, but that having more money to manage can dull performance because it is harder to move in and out of securities without moving their prices.
In considering a fund, as with any product or service, it is essential to evaluate not just what it costs but also what it provides in return, advisers say. Just as stocks and bonds can be false bargains, so can funds themselves, particularly when a portfolio is a de facto index tracker priced like something that is actively managed.
"Lower is better, but knowing what you're paying for is important," said Ross Levin, founding principal of Accredited Investors, a firm of financial advisers that manages US$1.4 billion of client assets. "You don't want to pay for a fund with movements similar to the market; you're much better off buying an index fund. You only want to pay for management because you think it can add returns."
In his view, that is more likely to be the case with managers whose particular investment strategy is out of the mainstream, as in certain types of hedge funds.
There are cost considerations even when buying ultracheap exchange-traded funds (ETFs), Mr Levin added. As low as their expense ratios are, ETFs can become costly for investors who buy shares repeatedly - for example, when using dollar-cost averaging (investing a fixed dollar amount periodically to reduce the average cost per share).
Those investors would be better off buying ETFs that are offered commission-free by discount brokers like Charles Schwab or Fidelity, he said, while someone putting a lump sum to work should try a portfolio run by a large operator like BlackRock, which sells ETFs under the iShares brand.
As for mutual funds, Mr Levin recommends Vanguard for its index trackers and T Rowe Price for the reasonable costs of its actively managed portfolios.
Ms Benz also likes those two, and she lauded Vanguard for its ability to keep down the costs of its actively managed funds, too. The firm's scale allows it to drive hard bargains on the fees that it pays to advisers that it hires, she said, highlighting Vanguard Wellington as "a very low-cost fund that has made a very good case for itself". Other fund families that she favours in part for their low expenses are Dodge & Cox, Harbor Funds, Oakmark, Royce and Ariel Investments.
Jeremy DeGroot, chief investment officer of Litman Gregory Asset Management and a contributor to the No-Load Fund Analyst, a newsletter published by an affiliate of the firm, added a third vote for Vanguard, calling it "a firm to look at if one wants to screen on low cost first and foremost". He is also a fan of Oakmark.
Mr DeGroot is not particularly drawn to low-cost funds, but he is inclined to shun funds with annual expenses that rise above certain levels for certain types of portfolios, such as 1.5 percentage points for ones that specialise in smaller companies or foreign stocks. "But even there," he said, "we will make exceptions for newer funds with very small asset bases that with some growth will be able to bring their expense ratio down to reasonable levels."
Ms Benz acknowledged that cost was just one of many components of fund performance, but she emphasised that it was an especially good one for investors to focus on.
"Low expenses tend to be the best predictive factor when trying to figure out whether a fund will outperform," she said. "It's true that a cheap fund is not necessarily a good fund, but if the goal is to stack the odds in your favour, a cheap fund is the way to go." - NYT