Brent Sheather: Do high fees equal high performance?

The chief executive of one of New Zealand's largest fund managers was quoted in a recent weekend newspaper as saying that it was "relatively easy to prove that fees are not a determinant of performance".

This extraordinary comment was made in the context of a discussion of the annual management fees of a provider of unit trusts to New Zealand retail investors.

Management fees have been the subject of more misinformation than the D-Day landings but some trends are clear: fund managers with high annual fees tend to argue that fees don't matter and the promoters of passively managed index funds with genuinely low fees argue they do.

I contacted the fund manager concerned and, despite the quotation marks, he maintained that he was misquoted.

What he did say, apparently, was that "fees are not the primary determinant of performance, evidenced by the fact that performance dispersion of managers across most asset classes is considerably greater than the dispersion of fees".

What this means is that fees range between about 0.2 per cent and 2.0 per cent a year but managers' performance can vary by 10 per cent a year or more.

Be that as it may, it is impossible to estimate the future performance of managed funds.

But we do know, most of the time, the annual fees involved, so that is about the only place to start when you are trying to estimate future returns.

But how significant are fees and who are we to believe in assessing their significance? This is important because Stage 1 marketing introduces the idea of the "psychology of pricing" theory, which says that people tend to equate higher prices with higher quality - that is, "you get what you pay for".

Obviously all the industry participants have a vested interest so where do we go for an independent view?

Academia, of course. PhD aspirants love analysing this sort of thing and there have been quite a few studies which have got to the bottom of the matter.

Imagine my surprise when, just after reading the local fund manager's revelation on fees, I picked up the October edition of the Journal of Finance and, lo and behold, one of the lead articles is "The Relation between Price and Performance in the Mutual Fund Industry" by a couple of professors from the University of Madrid.

There is a god! So let's see what they have to say on the matter.

The authors of the study used a database of all the open-ended mutual funds available in the US and their performance in the period 1961 to 2005, excluding index funds. Their conclusion - funds with high fees underperformed even before the deduction of fees.

The authors explain this by suggesting that "funds with poor past performance have a pool of investors that are less sensitive to fund performance". That is, they are stupid.

"Faced with an inelastic demand for their managed funds the underperforming funds optimally increase fees."

Translation: the fund manager thinks if unit holders are stupid enough to ignore our poor performance maybe they won't notice high fees either. There is anecdotal evidence that this happens in New Zealand as well.

The Spanish study referred to various other academic papers highlighting the fact that high fees meant lower performance after fees.

One 20-year study by Mark Cahart in the March 1997 Journal of Finance found that fees almost completely explain equity managed fund returns.

"I demonstrate that expenses have at least a one-for-one negative impact on fund performance and that turnover also negatively impacts performance."

There is another way to consider the impact of fees.

We can get a better perspective by looking at the future return on shares and how the annual charges made by fund managers compares.

The world stockmarket has returned 8.4 per cent a year in US dollars since 1900, according to London Business School professors Dimson, Marsh and Staunton.

But in an article in the Financial Analysts Journal in 2002, highlighted in this column, Robert Arnott noted that historic returns are irrelevant as the dividend yield back at the starting point was much higher than it is now and share performance had further benefited from shares becoming more expensive in terms of PE ratio.

So how do we get a reasonable perspective on fees?

We can look at investing in shares in terms of their opportunity cost. Instead of buying shares, we could put together a portfolio of government bonds, with next to no annual management fees. To assess the impact of annual fees on shares, we should compare them with the extra return we can expect to get from equities over bonds.

This is called the equity risk premium (ERP) and Dimson, Marsh and Staunton have done a bit of work on this subject, most recently in the 2009 edition of the Credit Suisse Global Investment Returns Yearbook (GIRY).

Without going into too much detail, Dimson, Marsh and Staunton conclude that in the next 100 years, shares will probably outperform bonds by about 3 per cent a year.

With fund management, administration and turnover fees incurred by most actively managed funds more than 2 per cent a year, not much more comment is needed.

If your shares are monitored by a financial adviser on a platform incurring another fee of 1 per cent a year, that would be enough to eliminate the risk premium entirely - in other words, after fees you get the risk of equities and the return of bonds.

Not surprisingly, there is a trend by institutional investors to low-cost funds. Unfortunately, though, if everybody switched to index funds the market would cease to function properly.

So we all have a responsibility to own a few actively managed funds but, contrary to what we might read in the newspaper, we need to keep a close eye on performance and the extent of those fees.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.