Toronto - Conventional wisdom has discouraged investing in high-fee funds, arguing the evidence shows that low-fee funds outperform them.
New research is turning that advice on its head. Initially motivated to investigate the kinds of stocks both types of funds hold, a group of researchers found that prior studies failed to account for significant differences in the characteristics of those stocks and the risk they represent.
“These characteristics are ones that have recently been found to be associated with different expected returns,” said Mikhail Simutin, one of the three researchers, and an associate professor of finance at the University of Toronto’s Rotman School of Management.
Once those differences were considered, the researchers discovered that high-fee mutual funds outperformed low-fee funds, before factoring in management expenses. That doesn’t mean they’re superior, Prof. Simutin stressed. With fees in, the two kinds of funds showed similar performance.
The researchers analyzed data for nearly 3,000 U.S. mutual funds between 1980 and 2017. The funds held at least 10 stocks and $20 million in assets.
High-fee funds were shown to prefer stocks of young companies that grew their assets quickly and had not yet achieved high profitability -- characteristics not typically considered in performance assessments. Compared to low-fee funds, stocks held by higher-fee funds grew their assets 50 percent faster and had 18 percent lower gross profit margins than stocks held in low-fee funds, the researchers found. The research used recently formulated (or proposed) models capable of identifying differences in average returns among stocks due to different levels of profitability and asset growth.
These fast-growth, low-profitability stocks are expected to earn lower returns compared to market benchmarks because they also carry lower risk to the investor. And this has been the oversight of typical fund comparisons – the risk profiles of high- and low-fee funds’ stock mixes are not the same.
“You can’t say that an investment with a higher return is a better investment without taking risk differences into account,” said Prof. Simutin.
The finding held even when comparing index funds (excluded from the main sample) to actively managed ones: average index fund performance was similar to that of actively managed funds in the lowest fee percentage category. So were their fees -- 0.58 percent compared to 0.57 percent.
Fees for U.S. mutual funds typically range from 0.5 percent to two percent a year. When the researchers examined those fees, they found that higher fee ratios were due to the fact that high-growth, low-profitability companies were harder, and therefore costlier, to price.
Prof. Simutin was most surprised by the “very strong difference” in the kinds of stocks held by high- and low-fee funds. “Once we saw the differences, the rest was less surprising,” he added.
As for investors mulling over their options, he advises them to only judge a fund’s performance “after accounting for risks that matter,” he said.
Prof. Simutin co-authored the research with Jinfei Sheng of the University of California, Irvine and Terry Zhang, of Australian National University. It was published in The Journal of Asset Pricing Studies.
Bringing together high-impact faculty research and thought leadership on one searchable platform, the new Rotman Insights Hub offers articles, podcasts, opinions, books and videos representing the latest in management thinking and providing insights into the key issues facing business and society.
The Rotman School of Management is part of the University of Toronto, a global centre of research and teaching excellence at the heart of Canada’s commercial capital. Rotman is a catalyst for transformative learning, insights and public engagement, bringing together diverse views and initiatives around a defining purpose: to create value for business and society. For more information, visit www.rotman.utoronto.ca.
For more information:
Manager, Media Relations
Rotman School of Management
University of Toronto