Expenses Matter When Selecting Active Funds

Despite the overwhelming academic evidence demonstrating the superior, long-term performance of index funds, investors may want to invest in actively managed products. New research shows the importance of choosing low-cost funds.

David Nanigian, author of the study, “The Historical Record on Active versus Passive Mutual Fund Performance,” published in the April 2022 issue of The Journal of Investing, contributes to the literature by examining the performance of active managers from a new perspective. He began by noting: “A plethora of studies have documented the fact that mutual funds with higher expenses have lower performance. … This has led to a belief that a passive investment strategy beats an active strategy and the resultant rise in the popularity of index fund investing.” Given the evidence that suggests higher expenses are a main or sole source of the underperformance, Nanigian examined the performance of passive funds against that of comparable active funds whose expense ratios were closer to those of passive funds (such as Vanguard’s actively managed funds) – those in the bottom quintile of expenses.

Nanigian sorted funds into two groups: passive (funds classified by Morningstar as either index funds or enhanced index funds) and active. His data sample covered the period 1991-2019. Fund performance was evaluated based on the Carhart four-factor (market, size, value and momentum) model.

Economic theory suggests that if markets are efficient (meaning the current price is the best estimate of the fair value), active managers are unlikely to outperform on a persistent basis because of their higher expenses – not because they are not skilled. The reason that index (or the broader category of passive) funds outperform is simply due to their lower expenses. Thus, if markets are perfectly efficient, the only difference in risk-adjusted returns between active and passive investors should be their total expenses (not just their expense ratios but trading costs as well).