Choose mutual funds and ETFs with lower investment management expenses

Investment fund management fees can only be justified by individual investors, if higher net returns more than compensate for these fees.

Sadly, this is most often not the case with costly actively managed equity and bond mutual funds and with high cost exchange-traded funds (ETFs). In addition, you have no reliable way to tell beforehand which actively managed fund will return more than its costs, when compared to a passively managed index fund. 

Because higher fund fees cause the average actively managed fund to trail the return of index funds, your chances of picking a supposedly superior actively managed fund are greatly reduced.

Only a minority of actively managed mutual funds perform well enough to compensate for their higher fees in the short run. In the longer term, even fewer actively managed equity and bond funds will beat the market, because “superior” short-term performance is mostly due to luck rather than to skill, and luck tends not to last. 

Certain scientific studies have demonstrated that some professionally managed equity mutual funds seem to exhibit a very modest level of apparent skill in their ability either to choose stocks and/or to manage their stock portfolios. These funds may be slightly better stock pickers, and/or they may have better portfolio management practices. In managing their portfolios, these funds may not make the behavioral mistakes that many individual investors do, such as holding losers too long and selling winners too quickly. Scientific finance studies have demonstrated a very slight persistence in stock price trends for some, but not all equities. This persistence could benefit portfolio managers who hold their winners longer and sell their losers more quickly. Evidence of skill for bonds seems entirely lacking, so buying lower cost bond funds is clearly a better strategy.

(Note: Just because scientific finance studies do not support buying actively managed stock and bond funds on a net investor returns basis, this does not mean that professional money managers are not skillful. To the contrary, the level of professional expertise in portfolio management at most fund companies is very high. However, unlike American schools and colleges, the real-time securities markets have built-in grade and achievement deflators. On average, the markets deliver C level returns before costs. If your costs are lower, you are more likely to get an A or B. If your costs are higher, you are more likely to get a D or F. The major factor that adds to all the confusion is that market participants must put a current, risk-adjusted value on future economic prospects. Therefore, securities market prices are highly volatile. Market participants will eventually be graded on the impact of currently unknowable future events. Some will be lucky, while others will not be.)

Scientific studies, which show some minor level of skill among active professional fund managers, can help to perpetuate the active-versus-passive "debate." However, from the perspective of the individual investor, this tired argument is simply irrelevant.

Scientific finance studies have the advantage of being done after the fact, and they use large sets of historical data to see what actually did happen. Without a crystal ball, individual investors face the daunting task of trying to pick a few future winners out of a large crowd of losers that will not provide a positive net return after all additional fee, transaction, tax, and time costs are taken into account.

Even the scientific studies, which demonstrate some minor professional skill, do not show that this skill justifies paying the higher fees of active funds. On average, actively managed funds simply do not have sufficiently higher returns to cover even the higher management fees that they charge directly.  Furthermore, higher active transactions costs are sometimes left out of the evaluation, even though they can also drag down net returns for higher turnover funds. These studies usually do not account for increased taxes paid by individual investors caused by active trading. Finally, they do not measure the opportunity cost related to an individual investor's extra time spent on futile, ongoing efforts to pick "superior" funds that most often will not be.

An investor is better served by choosing from among the numerous mutual funds and exchange-traded funds that have decided to compete on cost and efficiency and that are trying to attract individual investors’ money by charging very low fees. Obviously, a decision rule that focuses on lower fees will strongly favor passively managed index funds over actively managed funds.

When screening mutual funds and ETFs, you should first set a relatively stringent upper limit on the annual expense ratio that you are willing to pay. With passively managed domestic index funds, .5% (one half of one percent) annually is a very overly generous upper limit. Many domestic index funds are available with management fees under .1% (one tenth of one percent). Because of their variety, it is not as easy to generalize about screening of international and foreign index funds. However, lower management costs should still be a key screening rule for these funds.

With actively managed funds, you first have to ask yourself whether you have a valid reason for preferring them to passively managed index funds. If you have a good reason to select an actively managed fund, which most individual investors will not have, then you should still seek lower management fees among active funds. You might start screening with an upper expense ratio limit of .75% or even lower. However, even at that level you won't find much. The game with active mutual fund companies is to offer a wide variety of funds and some will randomly do better than average. Those funds will get more promotion and more stars, but random superior performance tends not to persist. You will pay higher fees and in the long run, compared to lower cost passive index funds, you end up with inferior returns net of those higher investment management fees and the higher taxes you pay related to a more active investment strategy.

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