Are Actively Managed Funds Worth the Expense Ratio?
Investment management fees have always been a hot topic – in particular, fees that aren’t explicit. A fund’s management fee—e.g., its “expense ratio”—falls in that category. This fee reflects the cost of running a fund. This includes paying for staff (including analysts and portfolio managers), and operational expenses.
This fee can eat away at your profits over time, and is synonymous to a gas leak that you don’t detect until everything blows up.
Certain classes of funds have been designed to have low fees – for example, index funds. Index funds have low fees because these funds aren’t actively managed. They simply attempt to mirror the composition of a broad market index without any extra management towards beating the performance of that index.
As a result, the returns should satisfy an investor as long as the market in which the index fund is tracking is going up.
It’s synonymous to placing a plane on autopilot. If the skies are calm, the ride should be smooth. However, passengers will surely want an experienced pilot as soon as the plane hits turbulence.
Below is a comparison of a popular index fund that tracks the S&P 500 to another popular actively managed fund designed to beat the S&P 500 (A-shares). These funds aren’t named to avoid the appearance of providing a recommendation.
The actively-managed fund has a front-end load of 5.75% and an annual expense ratio of .68%. The index fund has no front-end load, and an annual expense ratio of .18%.
Let’s look at the 5-yr performance without adjusting for fees. As the market declined, the actively-managed fund in blue tended to outperform the index fund in orange. However, the index fund outperformed the actively-managed fund during rising periods in the market:
Past performance does not imply future performance. The chart above includes reinvestment of capital gains and dividends. Also keep in mind that mutual funds typically have minimum initial investment requirements. Read the prospectus carefully to understand all fees associated with buying a fund.
In this case, incorporating the front-end load and the expense ratios may change the relative performances. However, this does not imply that either type of fund would beat the other across the board (e.g., in all target markets).
As an investor, discuss fees carefully with your advisor, and consider lower fee alternatives when discussing mutual fund investing.
Comments are closed.