Most Popular ArticlesNovember 3, 2009
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A convenient reason to eliminate a fund from consideration is high expenses. While that criterion alone is often a good guideline, blindly relying on it can cause you to overlook otherwise attractive funds.
Therein lies the expense paradox – sometimes you have to pay higher fees for superior management.
Advisors have come under pressure from a number of quarters – peers, professional organizations, regulatory bodies, and clients – to assign primacy to expenses in the fund selection process. Retail investors hear, especially from the media, that they must avoid “expensive” funds because those high expenses will depress future returns. Fiduciaries are counseled to avoid funds (and share classes) that have “above-average” expense structures. If any of this deserves credence, we should be able to find a clear relationship between fund expenses and returns.
It’s easy to construct a case to show that the admonitions make sense. We can do so by comparing the returns (excess over bench in this example) of all of the share classes of the same fund, as shown below for the Allianz NFJ Small Cap Value, and by relating them to associated expenses. (Keep in mind that mutual fund returns are reported net of expenses.)
A clear indirect adverse relationship between expenses and returns emerges. But this connection is not surprising; the underlying portfolio return of each of the fund’s share classes is the same, so return differences among the share classes may correctly be attributed to their respective expense structures. (Let’s consider loads to be trade commissions and exclude them from this discussion.)
Assuming that you have decided to invest in the Allianz fund, and that you have complete freedom to choose one share class from the array of options, common sense seems to dictate buying the institutional (Instl) share class. It has the highest return, which necessarily means that it has the lowest expense ratio.
It’s reasonable to expect to see essentially the same return/expense pattern when examining other multi-share class fund products. So let’s broaden our focus by including another fund, Van Kampen Small Cap Value.
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