Morningstar research examines stock and bond fund fees

There are 1,600 fewer stock and bond funds than only a decade earlier, and lower fees are increasingly driving outperformance in those investments, a Morningstar study concluded.

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Since “fee differences appear to be explaining more of the performance margins between funds than before,” that means their expenses “ought to rank at the very top of one’s short list of criteria to consider when choosing funds,” according to an analysis last month by Jeffrey Ptak, a managing director with Morningstar Research Services. The accelerating consolidation and commodification in stock and bond funds offers financial advisors and wealth management firms more opportunities to explain their value to prospective clients.

Falling average expense ratios to the tune of rates that are more than 50% cheaper across stock and bond mutual funds and ETFs represent one of the dominant investment trends of the past 25 years. More investors “just generally realize that lower-cost is better,” said Michael Helveston, founder of Exton, Pennsylvania-based registered investment advisory firm Whitford Financial Planning. 

However, they display a wide variation among do-it-yourself investors who are more cost-conscious and more casual people who “may not really dive into it” beyond asking about a friend or family member’s recommendation or hiring an advisor, Helveston noted. He frequently points out to clients that a fund with a 1% fee must outperform one with a 0.50% rate by more than half a percent to be a better investment.

“As an advisor, then my value can be more in the weightings of the different asset classes and the rebalancing that’s proactively done,” Helveston said. “I tell people not to hire me because I can pick the best stocks or I can pick the best funds. That’s why I think the commodification has been happening, which I think has been good for the consumers as well. Active management doesn’t hold a lot of weight if you can perform similarly for less.”

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Smaller volumes, cheaper stock and bond funds

The net losses in the volume of stock and bond funds is approaching levels unseen since the Great Recession. Over a 10-year span ending in early December, the ranks of stock and bond funds plummeted by 1,651, Ptak’s analysis showed. In general, the remaining funds are older, and the newer stock and bonds vehicles’ performance is lower than those with a longer tenure.

“Though the results varied by trailing period and category, newer funds generally had a harder time keeping up with older funds before fees,” Ptak wrote. “Thus, to the extent newer funds could be considered ‘weaker hands,’ the dearth of new fund launches could be pitting the remaining, higher-performing funds against each other.”

In that paradoxical backdrop that he described as posing the question — “What if less competition stoked more competition?” — the fees account for a bigger share of the disparities in performance. As part of the analysis, Ptak sorted stock and bond funds into one of five groups based on their expense ratios and measured their average annual returns over the last decade. The cheapest 10% achieved the best return, at 10.3%, while those with the second-lowest costs netted 9.81% annual gains, the third group got 9.18%, the fourth 8.77% and the last 8.09%.

“Not too surprisingly, cost differences explained relative performance, with cheaper funds beating pricier funds over the 10-year period,” Ptak wrote. “What’s more, the cheapest funds beat the priciest funds over every rolling three-year period that made up this span, the average margin of outperformance being nearly 200 basis points per year.”

The impact of fees rendered other factors in outperformance to a mere “marginal” status, which is a “marked contrast” to the prior decade in which the cost was important but not as definitive as today, he wrote. 

“The most obvious takeaway for investors is that costs matter,” Ptak concluded. “The corollary to this is that competition has only become more stifling for active funds. Firms are launching fewer new funds, effectively shrinking the pool of ‘weaker hands,’ and the range of prefee returns looks to have narrowed absent the more idiosyncratic performance of newer entrants. Thus, the potential payoff of picking a winning active fund has likely shrunk before fees, which should inform how investors assess whether to index.”

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Still a surprise to the general public

None of those findings likely surprise advisors and wealth management professionals who have watched the commodification and consolidation play out across investment funds in recent decades. In many circles of the profession, the terms “stock-picker” or “rep-as-portfolio manager” have earned a negative connotation in comparison to the comprehensive, dynamic financial planning process. Firms like Vanguard, BlackRock and Dimensional Fund Advisors built their fund empires based in large part on their cost differential. A wealth of helpful online calculators demonstrate how cheaper fees compound into bigger gains over time.

Regardless, advisors still field queries at social gatherings about “what’s hot” in the capital markets. Helveston typically responds “with a non-answer” or, if pressed on just one tactic to take, advises them to buy a total market index product. These days, planners can guide clients through advice that is “less about products and investments but really helping people make good decisions” and building secure retirement nest eggs, he said. In theory, at least, that should appeal to more investors than a pitch based on choosing the hottest stock or product.

“I tend to explain to people that that’s not really what I do,” Helveston said. “Investing efficiently is part of that, so I don’t give a recommendation for a one-off, ‘What do I do with the next $5,000 that I invest,’ because it’s got to be part of a bigger plan.”