Fund Fees; an investor's worst enemy or a misunderstood marketing tactic?

January, 2021

Skilled active management can outperform low-fee index funds over a market cycle, even when accounting for much higher fees. As your advisor, our role is to make recommendations to you based on the best performing funds to meet your needs. When it comes to equity funds, our top fund recommendations have matched or outperformed the index and corresponding low-fee funds over the last market cycle, even after accounting for the differences in fees between the two investing styles. Rather than a strict focus on minimizing fees, we recommend considering net performance after fees over long time periods as a better indicator of fund suitability when making investment decisions.

You may have heard a lot of buzz in the media regarding investment fees. Television and radio commercials have recently been telling consumers that if they pay higher fees, they will in turn receive lower returns. The implication is that investors should prioritize lower fees above all else. These ads tell you that by paying a higher fee, you are sacrificing growth over the lifespan of your investment, and in some ads the companies even quote example returns that seem staggering. However, these results are an artifact of how these companies have done the comparison and are, at best, misleading.

When most investors think of low-cost investment funds, they are generally envisioning passive, index mirroring Exchange Traded Funds, or ETFs for short. The ETF is simply a type of fund, or package of stocks and bonds, similar in overall structure to mutual funds (MF). Although mostly similar, both ETFs and MFs have their own unique advantages and disadvantages in comparison to one another; the bigger differences come when comparing active versus passive fund management styles. A passive index fund suggests that the fund invests in a mix of securities that mirrors the ETF’s target index as closely as possible. Proponents of this strategy argue that since indexes generally trend upward over time, this strategy will predictably yield long term gains.

In contrast to passive funds that simply attempt match the index, actively managed funds are run by teams of investment specialists, that do extensive research on each company they invest in. In many cases, this research involves meeting with the company to discuss their business model and go through the company’s books, market analysis and tactical positioning, among many other metrics all yielding an informed decision-making process behind investment decisions (Fig. 1). Unfortunately, this extra work requires staff, supplies and infrastructure, all of which necessitates a higher cost to run the fund. However, the flexible mandate allows the management team to differ from the underlying index, which yields the potential to outperform that index over time.

One of the favourite examples that passive index advocates use to support the idea that low-cost index funds are better than actively managed funds is the idea that the average of all index mirroring funds performs better than the average of all actively managed funds over time. However, this statement is incredibly misleading and somewhat intended to confuse the novice investor. In general, since there are numerous fund companies, all with their own management teams, each team with different levels of experience and skill and employing their own strategy, some actively managed funds will naturally perform better than others. In fact, the performance range of actively managed funds can be quite large, especially in comparison to passive funds that all look very similar to the underlying index.

The difference in performance noted above between an index fund and an active fund is a direct result of the difference in strategy. The central goal of the low-cost passive fund is to yield a performance that emulates the index its tracking, and therefore to yield 100% of the return of the index. Since index funds do collect a small fee, which decreases return, passive funds are likely to yield on average slightly less (ie. 99.95%) of the index’s gains, but also slightly more (100.05%) of the index’s declines (Fig. 2). In contrast, because actively managed funds can incorporate tactical investment decisions that differ greatly from the index, there is a possibility to outperform the index on the upside and mitigate losses on the downside1. Additionally, active fund managers can also take advantage of decreased stock prices during market corrections and thereby outperform the index during a recovery2,3.

Of course, the average active fund does not outperform the index, and with the wealth of choice the individual Canadian investor currently has, deciding between funds can be overwhelming. However, our job as your advisor is to do the research and to recommend funds best suited to your goals. How would the funds we recommend stack up against the index over time? To answer this question let us have a look at our most highly recommended equity funds from three different categories: 1) Canadian equity, 2) Global equity, 3) US equity. As we go through the below examples, it should be noted for complete transparency, we will be providing return data net of all fund fees for active mutual funds, in other words the return data as displayed will be after the fund management fee, advisor fee and dealer fees have all been subtracted (noted as MER in each graph; current as of January 2021 from Morningstar). In contrast, we have included only management fees for the passive index funds as you would pay through a do-it-yourself platform.

The main stock index in Canada is the Toronto Stock Exchange (or TSX), and hence most Canadian passive index funds will attempt to track the TSX. Over the past few years our top recommendations in the Canadian market have included the flagship Canadian funds from some of the top money managers in Canada: Fidelity Canadian Growth Company Fund, Mackenzie Canadian Growth Fund, and Manulife Dividend Income Fund. All these funds are classified in the Canadian space, but the mandates of each allow them to capitalize on opportunities external to the Canadian market if favourable conditions exist; a flexibility you will not find within the mandates of Canadian index funds. As a result, you will see that all three of the funds significantly outperform the TSX 60 over the span of the last 8.5 years (Fig. 3A); the earliest point at which all of these funds were available in the market.

As mentioned above, one of the clearest advantages of active management is that these funds can outperform during market volatility by altering asset allocation to become more defensive1, or buying shares of good companies whose stock price is depressed and primed for recovery2,3. The last three years has been an excellent example of market volatility, with two separate market corrections of 20% or more. In the bottom graph of the above figure (Fig. 3B), you will see the performance of the Canadian funds over this recent volatile period. While these three funds have all on average seen declines in line with the market, the ability for these funds to reallocate their underlying holdings to undervalued assets has allowed them to recover much stronger than the index, and in some cases, show more than double the returns over this time period as those of similar low fee passive funds.

In the Global equity space, due to the longer histories of funds available, we can examine almost an entire market cycle. If we run a similar comparison beginning in 2009, as the world emerged from the debt crises of 2008/2009, until current day we see a similar trend emerge. Both the Global Dow Jones Index (Global Dow), the most recognizable global index for the novice investor, and the MSCI All Countries World Index (MSCI ACWI), an index that we believe is more reflective of the global space, perform very well; more than doubling their respective values in this time. However, if we look at our three most commonly recommended global equity funds, each of the funds is able to outperform the Global Dow by a wide margin and match or outperform the MSCI AWCI by the end of the market cycle (Fig. 4A), something that low fee index funds would be unable to do as discussed above. All three funds also show more growth than either index throughout the volatility of the last three years, with a significant trend of outperformance evident during the immediate recovery phase (Fig. 4B).

The US investment atmosphere is the most difficult comparison for active mutual funds due to the relatively strong performance of the S&P 500 over the last decade. In this example we will run our comparison from 2013, the earliest point for which all examined funds were available to Canadian investors. During this seven-year period the US S&P 500 more than tripled in value and proceeded to set a record for length of a bull market run, conditions that are thought to heavily favour passive index investing over active management. Despite the advantage to index investing, both of the moderate risk Fidelity US Focused Stock Fund and Mackenzie US All Cap Fund outperform the S&P 500 index, as well as two popular low-fee S&P 500 passive index funds even after accounting for the higher fees (Fig. 5A). For those comfortable with higher risk, the Dynamic Power American Growth Fund significantly outperforms the market, adding a tremendous amount of excess value throughout the COVID-19 recession. All three of these funds strongly demonstrates the advantage of good active management through market corrections, easily besting returns from their low-fee counterparts through the volatility of the last three years (Fig. 5B).

It should be noted that none of these funds were chosen ad hoc for the purposes of outperforming throughout these comparisons. The only stipulation we placed upon funds in the above examples beyond being included in our commonly recommended funds list, were that the funds needed to be a) still open to new investors, and b) have a sufficient history to draw meaningful conclusions. Indeed, many clients will recognize one or more of the above funds from their own portfolios. However, the bottom line of these comparisons is clear, that good active management can outperform low-fee passive income investing over a market cycle for those buy and hold investors. Furthermore, good active management teams can provide significant benefits throughout market volatility where they can alter the underlying fund positions to take advantage of temporary opportunities, a strategy that passive index investing cannot replicate.

While we understand the desire for clients to avoid fees, it should be understood that avoiding fees at all costs may not be in your best interests at all times. Remember that fund fees exist to allow the management team the resources to do extensive research, and ultimately to help the fund managers make better, data driven decisions of which companies to invest in and which companies to avoid. More importantly though this research and analysis allows a skilled management team to rapidly alter asset allocation in order to take advantage of economic trends and temporary market opportunities in a way that passive funds simply cannot.

Fees are obviously one important metric when making investment decisions, however we would like to leave you with the thought that low fees do not directly lead to higher returns. Instead, we recommend that clients consider the net performance after fees over long time periods as a better indicator of fund suitability when making investment decisions.

1. “Do Mutual Funds Trade on Earnings News? The Information Content of Large Active Trades.”*Graphs adapted from Morningstar Advisor Workstation.

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