By LARRY SWEDROE
You may never have heard of a whelk. However, this little ocean creature can ruin an oyster’s day. A whelk looks like a conch, only a bit smaller. It’s equipped with a tentacle that works like an auger. The little whelk will drill a very small hole in the top of the oyster’s shell. Through this very small hole, a whelk can devour an entire oyster, sucking it out little by little until the oyster is gone.
Tim Mooney, D.K. Malhotra and Philip Russell, authors of the study Advisory Fee and Mutual Fund Returns, published in the Winter 2020 issue of The Journal of Index Investing, demonstrated that mutual fund expenses are the little whelks doing damage to your portfolio. Their study sought to determine if there is a link between the expense ratio of a fund and its returns by analysing the advisory fees of 945 mutual funds and their 12-month returns over the period 2000-2017.
The authors began by noting: “Mutual fund investors should be willing to pay a higher management fee to get a superior rate of return. But if there is no causality between advisory fee and fund performance, then mutual fund investors are better off looking for funds with a lower management fee.”
Following is a summary of their findings:
— There was a secular trend of declining advisory fees across the sample period — from 0.77 percent to 0.67 percent, a drop of 13 percent.
— The correlation between turnover ratio and returns was negative and statistically significant — increased turnover resulted in lower 12-month total returns.
— Market timing was negatively related to returns.
— There was no evidence that higher advisory fees are consistent with greater portfolio manager skill — paying more for advisory services in exchange for higher fund returns is not worth it.
Markets are competitive
Their finding that higher fund advisory fees do not translate into higher net returns to investors lends support to the model proposed by Jonathan Berk and Richard Green in their 2004 paper, Mutual Fund Flows and Performance in Rational Markets. Berk and Green explain that, in their model:
Superior performance cannot be predictable
Berk and Green continued:
Expected excess returns must be zero
In his 2005 paper, Five Myths of Active Portfolio Management, Jonathan Berk also explained why, even in the presence of skilled active managers, investors should not expect to benefit from that skill. This is what he said:
They don't call it the loser's game for nothing
The bottom line is that while the research finds that there are active managers skilled enough to generate gross alphas, the whelks in portfolio (in the form of advisory fees as well as turnover costs) more than erode the benefits of the skilled manager, leaving investors with net negative alphas. That makes active management the loser’s game.
Important Disclosure: This information is for educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Certain information is based upon third party data and may become outdated or otherwise superseded without notice.Third party data is deemed to be reliable, but its accuracy and completeness cannot be guaranteed.By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®. LSR-21-2