October 18, 2016


Fees or Performance?

In a recent interview on Bloomberg TV, I was asked the question:

“Should investors focus on fees or performance?”

My answer was that, while in the end it’s all about performance, it’s extremely difficult to identify reliable predictors of superior returns. So difficult that it may not warrant the effort, and at worst it can result in return-chasing behavior that harms rather than helps returns.1 Fees, on the other hand, are the one component of performance we have full control over. So focusing on fees makes sense.

On my ride home from Bloomberg’s studio, I continued to think about this question, and my answer. I realized that the question implies we need to make a choice between fees and performance, but we don’t. We can enjoy low fees and good performance.

For years, researchers and practitioners have looked high and low for predictors that would reliably identify which mutual funds would do best in the future. They’ve looked at all the likely suspects, and some pretty unlikely ones too, for predicting future fund returns. They looked at the past one-, three-, five- and 10-year performance of a fund, the size of the fund, the Morningstar rating of the fund, the number of times the fund manager has appeared on TV, and even the fund’s proximity to Omaha.2

Here’s what they found: the most powerful predictor is low fees.3 The single strongest statement I’ve read on the topic comes from Russel Kinnel, director of research at Morningstar:

“The expense ratio is the most proven predictor of future fund returns…. for every category over every time period.” 4

The reason I find Russel worth quoting is that Morningstar, with its famous five-star rating system, is in the business of helping investors pick the best funds, and this simple finding isn’t exactly the best thing for their business. We shouldn’t be very surprised when Vanguard’s head of research tells us that low fees are the most important predictor of future fund performance (and he has 5), but for the director of research at Morningstar to say this should get our attention.

It’s interesting to note that in other situations, the question of fees vs performance doesn’t have the same answer. For example, when choosing a lawyer or a restaurant, we don’t normally expect that the one who charges the least will give us the best performance. Is there something special about investing that makes it different from so many other economic activities?

There is. It’s a combination of the zero sum nature of stock picking combined with the difficulty in separating luck from skill, fueled by our love of a good story.

  – Victor

  1. You can read more about how return chasing can be harmful to investors here.
  2. I suspect proximity to Valley Forge, PA (home of Vanguard) would have given a different answer.
  3. For the purposes of this note, we’re limiting our discussion to US-listed equity mutual funds and ETFs. If you factor in taxes, then the effect is even stronger, because, as you know already, the lowest fee funds are predominantly index funds and index EFTs, and they tend to distribute the least amount of short term capital gains to their holders. In fact, ETF index funds, which make up a large and growing segment of the low fee space, are particularly tax efficient, generating very low levels of realized capital gains to their holders due to the tax efficiency of their structure.
  4. “Fund Fees Predict Future Success or Failure”, and “Predictive Power of Fees: Why Mutual Fund Fees Are So Important”, Russel Kinnel, Morningstar, May 2016.
  5. Vanguard’s “Mutual Fund Ratings and Future Performance”, June 2010.