In my post, The Expense Paradox, I attempted to demonstrate a lack of evidence for an indirect relationship between a mutual fund’s expense level and its performance, at least in the case of equity funds. I used a chart like the one below to support my observation. The notion that higher expense levels necessarily mean lower return levels cannot be supported, at least when it comes to equity mutual funds.
I went on to suggest that it may be imprudent to rule out considering funds with above average expense levels before carefully investigating all of the merits of those funds, and that the thoughtful investor ought to consider fund expenses in context with the value added by the fund manager. One way to do this is to express the relationship between fund performance and expense as a single number, an information ratio, which indicates how many units of risk-adjusted excess return are delivered per unit of expense. This ratio is shown as Expense Efficiency on the following chart.
Though the distribution resembles the one in the first chart, we now have additional information that may help to support a selection decision. We can see that the most efficient fund is Yacktman, though it has an expense ratio above the median value. We find that two funds, Gabelli Equity Income AAA and American Funds American Mutual have expense levels that are over 100 basis points apart yet are equally efficient. We see that among the least efficient are low-expense index funds and index ETFs, which may come as a surprise to some. (Some outliers falling to the extreme left of the original chart have been omitted.)
The expense efficiency value presented in the illustration covers an interval of ten years. It’s an average. What lurks under any average should concern an analyst, so in my work I calculate sub-period values to examine their trend and to find inflection points which may be connected to changes in the makeup of the management team or to asset growth.
The expense efficiency ratio is a useful statistic to me in my practice. It plays an important role in my ongoing fund search process. In one number it combines performance, associated risk and expenses. It can enhance a communication with clients in a way that effectively deals with their concern about expense levels. Further, it’s a number that can be used to rank funds and be part of a scoring system. Consider adding it to your analytical tool kit.
The Data: The equity indices used as explanatory variables for determining fund style were drawn from the Surz Style Pure® series. One of these, the large cap value index, also was used as the performance benchmark. The fund return series were drawn from the Morningstar® database.
The Method: The U.S. Equity Large Cap Value fund population is my own formulation. It consists of 133 funds having at least ten years of history as of the end of December 2010. Duplicate share classes for each fund have been eliminated leaving only one no-load share class that is available to RIAs on one or more of the three most popular broker platforms. The categorization of funds as large cap value is based on an analytical design of my own executed within the MPI Stylus Pro™ framework. I have a process for identifying and removing multi-cap funds from all of my peer groups and placing them in one of their own (value, blend and growth.)