Tuesday, August 6th, 2013 @ 3:36PM

By Dennis Miller

We’ve recently written a couple articles on ETFs—exchange traded funds—to help investors understand the difference between them and mutual funds and to show how for nearly every mutual fund you can find an nearly identical ETF that charges much less in fees. And each time we come out with a new article we get even more questions from readers.

So this week I’m turning to my colleague Vedran Vuk, senior analyst for Money Forever, to dig into the issue of fees, really put the numbers in perspective for you, and hopefully offer up an alternative or two. Take it away Vedran…

Should You Pay High Mutual Fund Fees for Good Performance?

Over the last five years, 65.4% of active, large-cap fund managers failed to outperform the S&P 500; 81.6% of mid-cap fund managers lagged behind the S&P Midcap 400; and 77.7% of small-cap managers were outperformed by the S&P SmallCap 600.

Since the majority of mutual funds can’t beat the S&P 500 or their respective indices, what’s the point of paying 1.5% in annual fees when one can buy the S&P 500 ETF for an annual fee of 0.1%? To be blunt, there really isn’t any point… unless one enjoys wasting money.

One common objection to my argument: Doesn’t it make sense to pay higher fees if a fund’s performance is good? That just seems like common sense. If someone does a good job, he should be rewarded. If the manager grows your portfolio, it’s all right for him to charge a little more.

So, is it OK to pay more for funds with a good track record? My answer is a resounding NO.

Let me explain. Suppose that you’ve been reading about cheaper alternatives to mutual funds, and you’d like your financial advisor to suggest some options. However, at the same time, you tell the advisor that you’re willing to pay higher fees for funds with a good performance history.

Usually, higher fees mean higher kickbacks from the mutual fund to the advisor. By telling the advisor that performance overcomes fees, he still has the same bad incentives in place. All he has to do is find a fund with both good performance and a high fee. Well, so what? Isn’t good performance what matters?

In any given year, some mutual funds and ETFs will do well and some will perform badly. Some of those funds will be high-fee funds and some will be low-fee funds. There are thousands of mutual funds and ETFs out there. It’s not particularly difficult to find one with both good performance and a high fee. By accepting high fees on funds with solid past performance, you’re really not beating the financial advisor and the expensive mutual funds at their game.

If past performance is an important criterion for your fund selection, what you should really insist on is the combination of good performance and low fees. As I said earlier, there are thousands of funds out there. Finding a fund with good performance and low fees is hardly a difficult task, especially with the assistance of a financial advisor, but you can do it on your own too with a little patience.

But if both funds are performing well, does it really matter? Yes. Remember that fees are a percentage of assets. They are not based on returns, as is often the case with hedge funds. Sure, if the fund grows, the mutual fund company will earn a little more. But the bulk of the fee is earned regardless of its performance. For example, if the fee is a very large 2%, you’re still going to pay that 2% even if the fund stays flat. If the fund drops 30%, you’re still going to be paying 2%. So, in some sense, you never pay for performance – investors always pay for assets under management.

Also, remember that past performance is just that… past performance. Each year is a new year. Would you rather be with a fund that earned 20% but charged 2% in fees, or a fund that earned 20% and charged 0.3% in fees? The answer seems pretty simple to me. With the first fund, you’re already down 2% from the start. In effect, you’re playing catch-up.

With all this said, there are times when high fees do make sense. If a particular fund has exactly what you’re looking for, then it might make sense to pay more. For example, suppose I really wanted a mutual fund that invested in Mexican dividend-paying stocks. There are no cheap options, except for a fund with a large 2% fee. In that case, it still might be worth it – assuming one believes that this is an incredible investment.

If your primary criterion is simply past performance, there’s no reason to pay for an expensive fund. In a recent issue of Money Forever we made this point by looking at the top 10 mutual funds from 2011. Then I posed a simple question: suppose you were an investor in January 2012 (for a full year of data) deciding to invest in these winners. How would your investments have performed? Of those 10 winners only three managed to outperform the S&P 500. The point here is that you can always find another fund or ETF with lower fees and good performance which much of the same market exposure as the expensive mutual funds. There are plenty of funds in the sea.

Posted by AIA Research & Editorial Staff
Categories: AIA Newsletter