Mutual Fund Fees do matter
Mutual fund fees continue to be scrutinized by the media. Many feel that the Management Expense Ratios (MERs) on mutual funds are too high especially given the fact that the last 10 years have been far from rewarding for investors.
So, are MERs really too high? Does a higher MER mean better returns or lower returns? The debate may forever continue as some advocates of low fee mutual funds and Exchange Traded Funds (ETFs) suggest that investors should first minimize fees as much as possible because they have the biggest impact on long term performance.
Others might reason that they would be willing to pay higher fees for higher returns. So how often will higher fees give higher returns?
Related article: Paying Fees on Your Investments
I’ve done some ongoing research on mutual fund fees and the impact they have on performance for quite some time now. My first book, Mutual Fundamentals started my curiosity on the topic of fees and since that time, I’ve looked at the relationship between fees and performance 3 other times. The last time was in 2006. Most recently, I looked at it again given the tough markets from 2000 to 2010.
Once again, I studied rates of return over 1 year, 5 year and 10-year periods to see how fees impacted returns over different time frames. I also looked at four different categories of funds: Bond Funds, Balanced Funds, Canadian Equity Funds and Global Equity Funds.
My findings were fairly consistent with my past research, which further solidifies my belief that fees do matter. My findings are summarized below:
- Over 1-year time frames, fees matter less because there is randomness and unpredictability in the markets over short time periods. There is very little correlation between fees and performance in the short term. For example, in the Canadian Equity Category, one year returns for the funds we looked at ranged from a low of 7.9% to a high of 124.8%. Fourty nine percent (49%) of the above average funds had high MERs and 51% had low MERs.
- Fees matter more over longer time frames. When you look at 5 and 10 year returns, there is a greater chance that the above average funds had lower MERs. For example, over 10-year periods, 72.5% of the best funds were lower MER funds and 27.5% were higher MER funds. For 5-year periods, 61% of the best funds were low MER funds and 39% had high MERs. It appears the longer the time frame, the higher the correlation between low fees and better returns.
- Low MER funds do not guarantee better returns. When I looked at low MER funds, 33% of low MER funds still had below average performance over 10 year periods. The relentless pursuit of the lowest-cost equity mutual funds is not a guaranteed strategy for success. Some low-fee funds have below-average returns over the past five years and some higher-fee funds have done considerably better than the average. What I found interesting was that 41% of those funds underperforming funds were index funds. In other words, don’t buy an index mutual fund and pay an MER because you will never beat the average. Here’s where a low cost ETF might be a better strategy.
- Fees matter more with fixed income funds than equity funds especially over the longer term. Over 10 year periods, 97.5% of all the top performing Canadian Fixed Income Funds had below average MERs. When I looked at 1-year returns, only 67% of top performing Cdn Fixed Income Funds had lower MERs. Although lower MERs in fixed income funds have a higher probability of outperforming over all time frames, there is still less correlation in the short term.
The bottom line
When choosing mutual funds, fees do matter but more over the long term than the short term. If you are the type that trades mutual funds regularly, fees should matter a lot less. At the end of the day, value equals benefit less cost. Look for funds that provide good value which means you will need to look at fees but don’t necessarily chase the lowest fee. Proper analysis of mutual funds requires a multidimensional approach where you look at many different criteria and not just fees or performance.