Let’s face it: costs matter. Whether we’re shopping for groceries in a supermarket or choosing the services of an investment advisor, we are conditioned to look for value. Here’s what that equation looks like in its simplest form:
What I get – What I pay = Value
So, we can increase the value of what we receive either by getting more “stuff” (in this case, better investment returns) or we can do it by paying less. All else equal, a lower cost strategy will outperform its higher cost counterparts by the amount of difference in cost. That’s pretty simple and easily understood by most investors.
The problem, however, is that higher cost strategies often promise better risk-adjusted returns. Whether it’s illiquid hedge or private equity funds or actively managed mutual fund strategies, investors are always looking for an edge and, therefore, often lured by the promise of higher returns. While costs are finite and known, the higher returns often aren’t; manager performance can change wildly from year to year and is difficult to predict in advance.
So what is an investor to do? Chase higher cost and potentially higher return strategies or stay with a low cost approach? The weight of evidence would certainly suggest the latter to be the correct approach for most.
Consider the study below done by our colleagues at Dimensional Fund Advisors over the past 10, 15, and 20 year periods regarding manager performance1.
As you can see, there is a clear relationship between investment cost and manager performance. Hence, if you choose to pay higher fees, make sure that you only do so for truly differentiated advice or exposure; managers that claim to outperform but don’t have the track record or the research to prove it probably aren’t worth the additional costs. Additionally, make sure that you are aware of all expenses when entering into a new investment. Trading expenses, performance incentives, and implicit costs (like opportunity costs of not entering into other investments) are all ones that come out of your pocket, whether they are disclosed upfront or not.
1)The sample includes funds at the beginning of the 10-, 15-, and 20-year periods ending December 31, 2018. Funds are sorted into quartiles within their category based on average expense ratio during the sample period. The chart shows the percentage of winner and loser funds by expense ratio quartile for each period. Winners are funds that survived and outperformed their benchmark over the period. Losers are funds that either did not survive or did not outperform their respective benchmark. US-domiciled open-end mutual fund data is from Morningstar. Past performance is no guarantee of future results.