When it comes to any number of everyday items – cars, houses, technology gadgets – consumers love getting good deals, but they’re also apt to associate some level of prestige with higher prices. The automobile industry has long been an epicenter for such thinking.
Indeed, the more expensive Lexus carries with it more glamour than the equivalent, cheaper Ford. However, this behavior doesn’t extend to investing and that’s a good thing. Data have long confirmed that investors flock to low-cost funds. Rock-bottom fees are the primary reason why Vanguard and Charles Schwab are the second- and fifth-largest U.S. ETF issuers, respectively.
Advisors shouldn’t take those points for granted and assume that every client, particularly those new to investing, are well-versed in mutual fund and ETF economics. After all, there are still broad market, pure beta index funds floating around with expense ratios of 1% or more, indicating some issuers are capitalizing on unwitting investors.
Alone, that’s a value-add opportunity for advisors. It’s an increasingly prominent one in the fixed income space where, for some reason, clients may see “value” in higher fund fees – a scenario that’s arguably amplified following bond market rout of 2022.
For Bond Funds, Devil’s in the Details
In a recent note, Morningstart analyst Jeffrey Ptak points out that fixed income funds in the cheapest quartile offered only modest out-performance of pricier rivals in five of nine rolling three-year periods spanning 2011 through 2019.
He noted that the cheapest outperformed pricier rivals by just 0.24% per year. Obviously, that’s nothing to write home about, but advisors should not end the story there. Rather, that’s more beginning than completion.
“The priciest funds badly underperformed the cheapest in the three-years ended Dec. 31, 2022, a period that included last year’s selloff,” observes Ptak. “That doesn’t mean passive bond funds fared markedly better amid rising rates. But it throws cold water on the notion you had to pay up to navigate choppy market conditions. The results suggest exactly the opposite was true.”
He added that when the groups of bond funds are controlled for price, the least expensive offerings consistently beat costlier rivals in each of the rolling three-year periods. Now that’s something to boast about.
“And this was true in good times and bad. In fact, funds levying below-average expense ratios outgained those charging above-average expense ratios by a larger margin in the three years ended 2022 than they did in the three years ended 2019, which was a heady period for bonds,” adds the analyst.
Bond Fees Feature Predictive Power
Better than anyone, advisors know that there are no crystal balls in investing. Mediums and psychics are equally useless in predicting feature returns. However, bond fund fees can be instructive in terms of forecasting future performance.
At the very least, it’s accurate to say the lower the fee on a bond fund in client portfolios, the better the clients’ long-term outcomes will be in the fixed income space. There are other good reasons for advisors to advocate for penny-pinching with bond funds.
“Costlier bond funds not only return less than cheaper funds, on average, but they’re more volatile. That’s apparent in the chart below, which is identical to the previous one but in this case plots out funds’ subsequent average standard deviation of returns,” concludes Ptak.