Cheaper funds have higher chance of relative success – study

Funds with lower total expense ratios have a higher chance of succeeding against their category peers, both in terms of survival and outperformance, a Morningstar study into South African unit trusts has found.

The results are in line with similar international studies, notably in the US, which also show that investors have better odds of future success when fund selection take fees into account.

Kyle Cox, investment analyst at Morningstar Investment Management South Africa, says due to the compounding effect fees have on an investment in the long term, the firm has always stressed that it was an area that deserved attention. Yet, not much research has been done into fees as a predictive tool of outperformance among large categories of unit trusts in South Africa and it decided to investigate how this methodology played out in the local industry.

“While the results of the South African research were less clear than US comparisons, they still point to the fact that investors have better odds of future success when fund selection decisions consider cost as a factor,” the study found.

The research, which focused on the larger Asisa fund categories by assets under management, found that over a three-year period, the cheapest quartile of funds had a higher total return success ratio and higher average annualised total returns across the three South African categories that were analysed, namely the multi-asset low equity, multi-asset high equity and equity general categories. The success ratio is the percentage of funds within each category quartile that survived and outperformed the category average over the (three- or five-year) period ending December 2016.

Over a three-year period, the predictive power of fees was the strongest for the South Africa multi-asset low equity category, with the most expensive quartile of funds showing a total return success ratio of only 9.5%. This means that only 9.5% of funds in the costliest quartile survived and outperformed the category average over the three-year period.

Although the predictive power of fees was still apparent over the five-year timeframe, it was somewhat less evident, arguably due to market conditions during the period and the wide use of performance fees.

During the last two years of the three-year period, the local equity market has largely moved sideways. In market conditions like this, fees have a more significant impact. If the fund is earning 6% in returns for example, an additional 2% in fees will be a much bigger portion of the investor’s overall return than during a period when the fund was earning 16%, Cox explains.

The five-year period included an additional two years of bull market returns at the beginning of the period, which diminished the impact of fees to some extent.

The findings suggest that South African investors could use fees as a screening tool to assist in predicting the success of funds. Cost would appear to have a compelling level of predictive power on unit trust performance in South Africa, supporting the notion that investors should favour low-cost solutions.

“As the numbers do show, the success ratios are generally higher when you go for that cheapest quartile of funds,” Cox says.

Although the results provide category-wide statistics and there are exceptions, it offers investors a starting point and broad measure to use when selecting funds.

However, the findings do not suggest that merely picking the cheapest unit trust fund would automatically result in outperforming competitors over time. Morningstar Research considers five pillars to evaluate funds – the people, the parent, process, performance and price.

All these pillars are very important in deciding on an investment, Cox says.

“I think it is an interesting thing to use fees as a possible predictor of success over these timeframes, but it is certainly not the only thing that investors should use to guide their investment decision-making.”

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