How to think about funds expense ratios

Meet Ian, an individual investor who sees healthcare as a core part of a modern economy and wants to have more exposure to the sector than the market index provides. Moreover, Ian would like to focus on growth and have an international component. There are nearly 100 healthcare funds, 600+ international funds and 600+ growth funds. A staggering number. 

Knowing fees create a drag on performance, how might Ian think about fees as he selects funds?

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One argument is to pick the funds that track a relevant index (assuming there is one) with the lowest fee. The view is captured, the market weighs things in its own way, and the lowest fee ensures this is captured without unnecessary drag. Sure. That's one way. Of course, fees matter, but is that always a good rule?

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Of course fees matter, and here are some key points to remember:

• Fees are already baked into the fund performance charts Ian is shown.   
• The fee is paid continuously (in drips) through a reduction in the price of the fund (done automatically).
• Ian can see the fee number he is paying (e.g. 0.4% per year), but it is hard for him to know whether it is justified.
• The impact of fees compounds, and the divergence can be significant for him for larger fees and over long periods. 

To illustrate, this image shows the S&P500 index over the past 10 years along with 3 funds that track it perfectly but each with a different fee. Before fees, a 100k$ initial investment became 322k$ (blue line). But the fees knock 8k$, 16k$ and 24k$ off the orange, green and red funds respectively. For a 100k$ initial investment and over 10 years, Ian is right to feel this is a lot.

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The above facts also imply that if two funds had exactly the same performance (as seen in the performance charts and the data), but where one charged a much higher fee, it means that it generated an outperformance that was subsequently wiped out by the fee.

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Why are there fees anyway? 

Not all fees are waste that simply enrich the greedy fund manager. Ian is aware that some asset classes cost more to access, e.g. certain bonds, international or private assets. Even in the most active US equity market, small and mid cap equities are more expensive to trade, because they are more thinly traded. But fees can also be deployed for research, better execution, trading strategies and so on. Some funds even simply outperform, not by being better stock pickers but by having better processes. Processes that cost money, which allow them to edge out a better performance, exceeding the costs. 

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Fees vs the future.

Whatever the reason, funds need to overcome the fees and deliver better reward and/or risk performance. This creates a challenge for the fund manager. The higher the fee the greater the challenge.

But even if the fund has indeed delivered a better performance over its peers, the risk for Ian is that the fund fails to deliver that in the future. Willingness to pay more in fees boils down to confidence that the fund will continue to deliver.

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What justifies higher fees?

Ian takes the view that low fee funds are not always best just because they don't charge, but nor are high fees an indicator of quality.

Good risk management costs money, and Ian is happy to pay more in fees if a fund has a track record of doing better than their benchmark during rough periods. Good analysis costs money, and the longevity of the fund matters to him: he is more inclined to invest in funds with longer track records, even if they cost more, than in equally performing funds with similar mandates but lower fees and shorter histories.

Horizons matter to him also. When he wants to invest in a theme he expects to hold for a smaller than usual period, he's willing to pay a premium for funds that have recently exhibited outstanding performance. For other investments, such as core holdings he plans to be in for the medium to long term, he prioritizes lower fees.

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Investors are different. Enter customization.

Not everyone shares Ian's views. Some demand much more evidence to pay a higher fee. Others go by performance and risk. Some want more passive indexing and others want more active funds.

Any view you have on one aspect of the above, or all, or none, DAYOSS will take in your preferences about fees against factors like risk, reward and history, and adjust the scoring it shows you.

So when you see a DAYOSS score for a fund, it has holistically encapsulated all the information you gave the system. It will save you time and help you make better decisions selecting funds and building your portfolio.