Research from Morningstar shows that funds generally underperform by the same amount that they charge their clients, though there is a lot of variation
Low-cost index funds have put a lot of pressure on active managers to justify their fees, and new research from Morningstar shows just how difficult it can be to make that case. When you collect data from every US equity fund there’s a very clear correlation between expense ratio and alpha, unfortunately for asset managers (not to mention their clients) the correlation is negative.
“We find that the higher the price of a fund, the worse its performance tends to be, and the link between fees and performance is stronger for passive funds,” writes Morningstar analyst Michael Rawson.
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Funds, as a group, can’t outperform because they are a proxy for the market
When you stop to think about it, the trend is roughly what you would expect to see. Since Morningstar is including the expense itself in performance, and the aggregate portfolio of all US equity funds is a decent proxy for the stock market as a whole, you would expect performance before fees to average out to the market return (eg zero alpha) and after-fee returns to average to negative whatever fees were paid. Allowing for noise, that’s what we see in Rawson’s first chart.
If you do a scatter of every US equity fund instead of averaging things out you see the full variation in returns, which is considerable (the trend line is necessarily the same). There are a lot of funds that can honestly say they beat the market, net fees, over the last five years. This doesn’t tell us who made good investments and who got lucky, but fund managers as a group just cost their clients money.
Passive funds work, but they had better be cheap
To compare active and passive funds Rawson restricts the data to large cap equity funds, otherwise you would be comparing results from strategies that don’t really line up. The data shows that passive funds work as advertised: you generally get zero alpha before fees, so you underperform the market by about as much as you pay the fund.
You could interpret this to mean that everyone should be investing in the lowest cost funds they can find, but that’s not quite true. Active funds are the only one that have a chance of making up for their fees, assuming you can find a really talented fund manager. But if you’re going to invest in a passive ETF, make sure the expense ratio is extremely low.