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High Fees A Continued Drag On Active Funds

Todd Rosenbluth

In real estate, the mantra is “location, location, location.” In investing, one mantra is—or should be—“cost, cost, cost.”

Year-to-date through Dec. 8, the average large-cap core mutual fund rose 10.5%, lagging the S&P 500's 12.2%, according to CFRA. Such underperformance is not new, as the SPIVA scorecard confirms that it's been nine years since the average large-cap core fund was stronger.

In 2015, the average active fund lagged by 212 basis points. Such performance challenges are due in part to the 1.1% net expense ratio incurred by these mutual funds.

In CFRA’s proprietary mutual fund and ETF ranking systems, cost is one of three primary inputs (performance and risk are the others) separating the wheat from the chaff.

Mutual Funds Vs. ETFs

The above comparisons may seem unfair, since index returns are based on no such fees. So here’s an apples-to-apples comparison: mutual funds versus ETFs. Indeed, thanks to iShares, investors can get large-cap index exposure with the iShares Core S&P 500 ETF (IVV) for just 4 basis points; IVV was up 12.2% year-to-date, in line with the index it seeks to track.

In contrast, the BlackRock Large Cap Core Fund (MDLRX) is an actively managed large-cap core offering that has a moderately higher-than-average 1.14% net expense ratio. The fund was up 10.7% year-to-date through Dec. 8, and also underperformed the S&P 500 in 2014 and 2015. You can see below the higher fees for mutual funds limited the gains.

Sources: CFRA, Thomson Reuters Lipper, as of Dec. 8, 2016

As one would hope from active management, the fund is distinct from the index and holds approximately 80 stocks. At the end of October, it was overweighted to health care and info technology, while underweighted to industrials. In addition, it has no exposure to real estate or telecom services stocks.

CFRA is bullish on the industrials sector, believing many securities have strong fundamentals and still attractive valuations. At 8 basis points, the Fidelity MSCI Industrials Index ETF (FIDU) has the lowest expense ratio among the wide array of sector ETFs. FIDU is a market-cap-weighted offering, so General Electric (GE) and 3M (MMM) are 11% and 4% of the fund’s assets, respectively.

Fidelity also offers Fidelity Select Industrials (FCYIX), a more expensive, yet actively managed industrials portfolio. The mutual fund’s 0.77% expense ratio, while considerably lower than its Lipper industrials peer mutual funds’ 1.3%, has limited the fund’s performance relative to its in-house index ETF alternative. On a three-year annualized basis, FCYIX’s 8.3% was lower than FIDU’s 9.5%.

Sources: CFRA, Thomson Reuters Lipper, as of Dec. 8, 2016

While GE was also FCYIX’s largest holding, MMM was not among the fund’s 10 largest holdings due to management’s discretion. Relative to its index alternative, the mutual fund also had lower weighted average market capitalization, with construction and engineering company AECOM a sizable holding.

More Loyalty With Active Fixed Income

Though actively managed equity funds have shed assets to passive alternatives in 2016, investors remained somewhat more loyal to active fixed-income products, as active products were still net asset gatherers this year. Yet as the passive bond lineup expands, we think investors will increasingly seek out cheaper and often-better-performing products.

The PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB) is one such high-yield index-based ETF. PHB focuses on metrics that are traditionally used by active managers, such as an issuer's book value, gross dividends, gross sales and cash flow. The ETF has a 0.50% net expense ratio, which is much lower than the Lipper high-yield mutual fund peer average of 1.1%.

Meanwhile, the actively managed Invesco High Yield Fund (AMHYX) is offered by the same fund family and has a 1.0% net expense ratio. While this cost is moderately below average relative to mutual funds, it still creates a high performance hurdle to overcome to keep up with an index-based strategy.

PHB’s 3.8% three-year annualized total return was approximately 80 basis points ahead of AMHYX, and CFRA thinks the higher fee was a contributor.

Sources: CFRA, Thomson Reuters Lipper, as of Dec. 8, 2016

Consistent Underperformance

Such a record is not abnormal, as in the three-year period ended June 2016. The average high-yield mutual funds underperformed the Barclays High Yield Index by 130 basis points, according to the Mid Year 2016 SPIVA Scorecard.

CFRA believes investors should not rely solely on past performance metrics when assessing ETFs or mutual funds. The fund’s holdings and costs help to drive performance going forward.

But investors have a wide array of lower-cost equity and fixed-income ETFs and index funds to consider, often from the same asset manager.

There will always be some active funds that outperform, and CFRA stands ready to provide tools to sort through the universe for those seeking to beat benchmarks. Investors need to understand that identifying long-term actively managed outperformers remains quite difficult, particularly when the funds under consideration have relatively high fees.

Until asset managers bring costs to more competitive levels, investors in active funds will start the year with ground to make up.

At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at cservices@cfraresearch.com. Follow him at @ToddCFRA

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