Is Price Important When Choosing a Fund?

Fans of passive investment often cite the cost of active management as a negative factor. But smart investors should consider more than just the price of a fund

Emma Wall 15 June, 2015 | 9:19AM
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All this week we are running a Guide to Active and Passive Investing to help you, the investor, make smart choices for your portfolio.





Emma Wall: Hello, and welcome to Morningstar. I am Emma Wall and I am joined today by Chris Traulsen, Head of Research for Morningstar.

Hello, Chris.

Christopher Traulsen: Hi, Emma.

Wall: So, we are here today to talk about price. It is one of our five Ps, one of the things that we consider when and rating a fund here at Morningstar, why is price important?

Traulsen: There is two ways to think about it. There is, first of all, vast quantities of academic research including some of our own research at Morningstar that shows that it's one of the better predictors of future outperformance of funds.

The second way to think about that is more intuitively is just to say lots of things are outside of our control in the investment world. Managers come and go, styles come in and out of favour, markets can go up and down, but price and the costs you are paying for that fund is the constant and it's a constant negative alpha effectively, because you don’t pay for beta, being applied to your return stream year after year after years. So, the more you can do to manage that constant in your favour, the better off you are as an investor, all else being equal.

Wall: It's not that easy to do all the time, though is it because the price that you can see easily that the fund manager may represent is not always the full price that you pay.

Traulsen: No, you are very right about that, so what's called an AMC of a management charge here in the U.K. may or may not include another element. RDR has made a huge difference because now the distribution element is outside the fund context and that helps you but there can be custodian fees and admin fees and all sorts of things.

The big element that's not disclosed anywhere is the trading cost of the fund and that would include everything from brokers' commissions, but also market impact or opportunity cost. So if you are running a big fund and you are a manager, if you make a trade all at once, you might drive that price up or down against your favour and cost yourself money.

If you spread it out over time to sort of tamp down that market impact, the price could still move against you over that time, it could cost you. So that's one of the areas where investors don't have much information and that can be easily higher than the ongoing charge itself in some cases.

Wall: So let's take a simplified formula and say that a fund delivers 3% a year and you have a choice between Fund A that charges you 1% and Fund B that charges you 1.5%. Of course, all other things being equal, you are going to go for the 1% fund.

However, price in isolation should not be the only consideration for investors, should it? We have four other Ps that we tell people to take into consideration. Perhaps you can explain a little bit more about why price should not be your only concern?

Traulsen: Sure. I mean it's like anything. You wouldn't just go by the cheapest of anything unless of a complete fungible commodity, right. I would tell you, if you are going to buy a passive fund for example, price should dominate your decision.

You need to ensure that they are competent in tracking the index, but beyond that there is no reason to pay extra for index fund management.

With active managers, it's a bit different. There is lot of levers being pulled. There can be different levels of experience. There can be different levels of complexity in the portfolios. So we do take all those kinds of things into account when we form our Morningstar Analyst Ratings on the funds. And as you know, we are looking at people, we're looking at parent, process, performance in addition to price.

So, it's one factor we look at and when we analyze the parent company, we look more broadly at the trend of how they price their funds and try to pick it up there as well. But we do think it's a factor you should consider, particularly if the fund's an outlier. That's when we start to get very concerned whether it starts moving out into that top or bottom quintile or quartile of fees within those peer groups, we think that's cause for tremendous concern.

But even then, the question is, how many levers does the manager have to pull to add value? Do we think he can overcome that fee in the future? And has it shown that ability in the past?

So, with an asset allocation fund that has broad spectrum to move exposures around and take on different kinds of risk, if we think somebody has got a lot of skill that that might justify a somewhat higher fee. But if we’re talking about long-only equity with a fairly low tracking error, you shouldn’t pay very much at all.

Wall: Chris, thank you very much.

Traulsen: Thank you, Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar