(Not) Paying for Performance

Do expense ratios for actively managed equity mutual funds represent pay for performance or pay for something else? In their July 2008 paper entitled “Performance and Characteristics of Actively Managed Retail Mutual Funds with Diverse Expense Ratios”, John Haslem, Kent Baker and David Smith investigate factors determining the performance of actively managed retail equity mutual funds, with emphasis on expense ratios. Using characteristics and return data for 1,779 actively managed U.S. equity mutual funds segmented by Morningstar category and contemporaneous returns for category-matched Russell indexes, they conclude that:

• On average, after expenses, actively managed mutual funds underperform category-matched benchmark indexes.
• The probability of a fund beating its benchmark varies inversely with expense ratio. A fund expense ratio at least one to two standard deviations below the mean for its category indicates a roughly even chance of beating a matched benchmark.
• Various measures indicate that fund performance relates positively to fund size and negatively to expense ratio (see, for example, the chart below), trading activity and front-end load.

The following chart, constructed from data in the paper, summarizes median five-year raw annualized returns of actively managed domestic mutual funds according to expense ratio relative to peer category. Each range of the relative expense ratio represents a shift of one standard deviation. (“High” is one to two standard deviations above the peer category mean, and “Very high” is two to three standard deviations above the peer category mean.) The chart illustrates the tendency of fund returns to rise as relative expense ratio falls.

In summary, mutual fund investors can enhance odds of beating passive benchmarks by focusing on funds with expense ratios that are among the lowest within category.

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