Based on my conversations with investors, I concluded that some people support active or passive investing for the wrong reasons. Since other people misrepresent this debate, I wrote this series as a way to provide additional context and give my personal outlook.
In full disclosure, I invest in both active and passive funds. Also, I recommend both types of funds depending on the client’s financial situation. In my opinion, neither style is superior to the other as investing is more complex than most people realize.
In last week’s article, I went over the fundamental differences between active and passive investing. For the rest of this series, I will provide deeper insight on how fees, performance, and risk play a role in the active versus passive debate. If you have not already, please read the previous article to get additional context.
In this post, I will go through how internal fees may affect investment performance. In addition, I will give my opinion on how much they actually matter in the grand scheme of things.
Index Fund Fees
A big reason why passive investing has become more popular are because of low fees. In order to gain market share, many fund companies introduced or expanded their selection of index funds. Since index funds in the same category are identical, the only way they compete is on cost. As a result, there has been a race to the bottom to see who can provide the lowest fees. In fact, this race came to a head a few months ago when a no-fee index fund was introduced.
Active Fund Fees
A main criticism of actively managed funds are that they cost significantly more than passive funds. Furthermore, critics attribute this higher cost as a big reason why active funds underperform the index. In my opinion, there is some truth to this mindset.
In the 2018 Morningstar Active-Passive Barometer report, it shows that low cost active mutual funds have a higher chance of beating the index versus more expensive ones. Below is a chart from the report that illustrates this performance difference.
This chart shows that fees, at least in part, can be a big detriment on returns. In the Intermediate-Term Bond asset class, the lowest cost active funds have a 33.4% higher chance of beating the index versus higher cost funds.
From a novice point of view, this chart makes active investing look undesirable. However, in my opinion, it is important to understand this chart in the context of fee trends in the industry.
According to an Investment Company Institute (ICI) Research report, the asset-weighted average expense ratios for both actively managed and index equity mutual funds have significantly fallen over the last few decades.
In 1996, the asset-weighted average expense ratio of active equity mutual funds was 1.08% and 0.27% for index equity mutual funds. In 2017, expenses fell to 0.78% and 0.09% respectively.
The following figure from this report illustrates this fee decrease.
* Please note that ICI uses asset-weighted averages to summarize the expenses that shareholders pay through funds. In this context, asset-weighted averages are preferable to simple averages, which would overstate the expenses and fees of funds in which investors hold few dollars.
Additionally, ICI states that between 2007 and 2017, passive index grew their market share by 20%. The chart below from this study illustrates the change in market share over the last decade.
How Does This Come Together?
In summary, fees do matter, but only to a point. Based on the decreasing fee trend and the increasing demand for low cost funds, I believe that the cost of active funds will go down significantly over the coming decade. In fact, a report by PWC suggests that active mutual fund fees will decrease by 20% by 2025. Therefore, if you only use Morningstar’s limited parameters, it is plausible to think that a higher percentage of active funds will outperform the index in coming years. Eventually, the fee argument might become a moot point.
While Morningstar’s report is factual, I believe it is important to read between the lines in order to understand the full picture. In my opinion, it is a mistake to think that fees are the only important variable when choosing an investment. Based on experience, I know that investing is more complicated than simply choosing the lowest cost investment. Therefore, you need to be informed of all the variables in order to make a good decision.