Not Surprising: Investors Like Cheap Funds

It’s often said there are not free lunches in financial markets, but that doesn’t stop market participants from hunting for what they perceive to be good deals. Fortunately, fund issuers are obliging and advisors and investors responding.

That’s particularly true when it comes to exchange traded funds and index funds – assets that have driven the low-cost investing boom. The fee compression facilitated by ETFs and index funds has created tangible benefits in the active mutual funds space where fees have steadily decline, though in aggregate, those products still carry higher expense ratios than rivals.

Vanguard, one of the kings of low-cost funds, highlights the advantages of inexpensive fees. The asset-weighted average fee on a Vanguard fund is 0.08% -- well below the industry average of 0.47% at the end of 2022. Obviously, that difference is meaningful, but the fund issuer illustrates just how meaningful. The firm notes that a client that starts with an initial investment of $250,000 will pay $179,212 in fund fees over 30 years if the expense ratio is 0.47%. If the fund charges just 0.08% per, the client pays $32,127 over those three decades. The example assumes 6% average annual returns.

Yes, Cheap Is Good

Yes, there are myriad life examples of getting what you pay for being sage advice. That saying isn’t relevant when it comes to fund fees. Fortunately for clients, advisors realize as much and appear to be taking the notion of lower fund costs leading to better long-term returns to heart.

“In eight of the last nine years, the cheapest 20% of funds across all Morningstar Categories have, as a group, accounted for 100% of the net inflows into all funds,” notes Morningstar. “Money has poured out of the remaining 80% during that time. The sums are staggering: More than $5.4 trillion has flowed into the low-cost cohort during this eight-year span, while $2.6 trillion has been pulled from the remaining funds.”

For many years, the gap between cheap funds and their pricier rivals was surprisingly modest in terms of asset-gathering proficiency. However, the gap steadily increased with time and swelled last year with significant contributions from advisors and their clients.

“In 2022, the gap in flows for cheap and expensive funds grew into a chasm. For the first time since 2017, the cheapest quintile of funds had a net flow advantage of over $1.1 trillion more than the remaining 80% of funds,” adds Morningstar.

What Constitutes Cheap

Cost savings, like beauty, are often in the eye of the beholder, but a good rule of thumb when it comes to defining “cheap” by fund groupings would be funds with expense ratios of 0.01% to 0.10% being the cheapest group, 0.11% to 0.20% being next and so on until getting to the 0.50%-plus area where those funds can be viewed as expensive.

That’s not etched in stone and some advisors might disagree. It should also be acknowledged that a fund’s fee isn’t indicative of its performance potential. In a hypothetical example, if a fund charging 0.70% per year delivers average annualized returns of 10% and its rival with the 0.10% fee returns 5% a year, it’s clear the pricier option is superior.

Still, two points cannot be ignored. First, high fund fees put clients behind the eight ball. Second, fund fees will continue declining.

“Not only has the median fund gotten cheaper over the past 15 years, the most expensive ones have, too. The most encouraging figure is the one representing the level that divides the cheapest 10% of funds from the rest. At 0.33%, this breakpoint was 45% lower in 2022 than it was in 2007,” concludes Morningstar.

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