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Fund fees: Is cheaper always better?

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Everyone chases low fund fees.

But despite the rush to index and exchange-traded funds, paying higher fees can sometimes be worth it, some contend.

A recent journal article by three Canadian business school researchers titled,“Cheaper is Not Better” argues that “high-fee funds significantly outperform low-fee funds before expenses and perform equally well net of fees.”

Although advisors acknowledge that higher investment fees may sometimes be necessary to achieve some specific results, many aren’t convinced that paying higher fees bring higher returns overall.

“All else equal, cheaper is better,” says John Faustino, chief product and strategy officer at Fi360 in Pittsburgh, who remains unconvinced by the Canadian study.

“Paying an asset manager higher fees with an expectation that I’d ‘net’ to returns equal from a lower-expense fund isn’t compelling to me,” he says. “I would have to expect some after-expense alpha to take the risk associated with what I perceive to be a ‘less-sure’ bet.”

If an advisor is going to consider a higher-expense mutual fund, it is critical to know what the higher fees are paying for, Faustino says.

“Are the higher-fee managers employing more or better researchers and content that can be reasonably expected to extract higher returns?” he asks. “Or are they spending more on advertising and marketing, or are they simply giving themselves higher pay?”

Faustino also says that as expenses have decreased for both actively and passively managed funds in recent years, the disparity between high- and low-cost funds is getting smaller.

And because the industry will continue to see fee compression over the next decade or so, it will become even more important to use lower-fee strategies for basic client investing, says advisor Eric Aanes, president and founder of Titus Wealth Management in Larkspur, California.

“We don’t believe in paying for active management in the large-company space, where the top 10 holdings are all the usual suspects,” he says. “Anything in that larger arena, we’re just going to index that out.”

Aanes says it is appropriate to look at higher fees and active management for more specific needs.

“It needs to be a unique strategy that fits a niche and serves a purpose,” he says, pointing to long-short credit funds and unique stock-picking strategies, such as mergers and acquisitions funds, as examples.

“But we’re going to monitor them on a much closer basis,” Aanes says, because the value they are meant to add may be either extremely specific or aimed at reducing risk rather than generating growth.

It is crucial to clearly explain and justify to clients the value of the added expense, he says.

“We’ll show them that maybe there’s not as much upside capture, but there’s significantly less downside capture,” Aanes says. “We’ll show them value-add of that manager, in that case creating that buffer or comfort zone.”

This story is part of a 30-30 series on navigating the growing world of choices for client portfolios.

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