Do Fund Cost and Family Matter?

Investors continue to hold more assets in mutual funds than in ETFs, even as S&P Capital IQ and others have cautioned repeatedly of the challenges actively-managed mutual funds face to outperform a given index as well as consistently generating above-average track records. Studies, including the semi-annual active vs. passive management scorecard (SPIVA) from S&P Dow Jones Indices generally favor passive management styles. However, those investors who think they can correctly identify which actively-managed funds could beat the odds now have a study for their side.

Recently published research from Fidelity Management & Research, itself an active equity manager with skin in the game, provides what S&P Capital IQ thinks is a compelling case that investors could narrow the active mutual fund universe of alternatives and have generated excess returns relative to passive fund alternatives. Of course, past performance is not necessarily indicative of future results.

Looking back to 1992, Fidelity analyzed how U.S. large-cap actively-managed and passively-managed mutual funds performed relative to their primary prospectus benchmark on a rolling one-year basis (including funds that did not exist the whole time period). On average, the active universe (814 funds) lagged their respective indices by 67 basis points per year net of fees, while the passive universe underperformed by 36 basis points.

To many, this would make the case for a passive fund such as Vanguard 500 Index Fund (VFIAX) or Vanguard 500 Index ETF (VOO), which each have net expense ratio of just 0.05%.

However, Fidelity's research identified two criteria for selecting U.S. large-cap equity funds that, when used as selection filters, have identified subsets of funds for which the historical average excess return was much higher. Those filters are fund expense ratios and fund family assets under management.

The fund expense ratio filter is the more straightforward, in our opinion, since higher expenses will eat into returns. The second filter utilized by Fidelity was to pick only funds from the five largest asset managers on the belief that they would have higher potential available investment resources to support research, investment platforms and trading through scale. While Fidelity did not list the "top-five" active mutual fund families in its study, S&P Capital IQ thinks they included American Funds, T. Rowe Price, Vanguard and, not coincidentally,

Fidelity. Since Vanguard, in particular, works with a number of sub-advisors who work independently of one another for its active funds, S&P Capital IQ is less confident that the research tools Vanguard could offer have the same benefits as they do at, perhaps, T. Rowe Price, which leverages a central research team.

However, using this filter, the average active fund (79 in total) outperformed by 5 basis points, a 72 basis point improvement from the unfiltered approach.

Fidelity Contrafund (FCNTX) is a large-cap growth fund with a 0.64% expense ratio that is also well below the Lipper average of 1.20%. Through March, the fund outperformed the S&P 500 Growth Index on a ten-year annualized basis by 104 basis points.

Vanguard PrimeCap Fund (VPMAX) is a large-cap core fund with a 0.35% net expense ratio that is well below the 1.12% Lipper average. Through March, the fund outperformed the S&P 500 Index on a ten-year annualized basis by 290 basis points. This fund is closed to new investors.

While we think the Fidelity research is compelling, we note that there are S&P Capital IQ five-star mutual funds from somewhat smaller fund families with similarly strong long-term records and modest expense ratios. One example is Dreyfus Strategic Value Fund (DRGVX 41). This large-cap value fund has a 0.73% net expense ratio and outperformed the S&P 500 Value index on a ten-year annualized basis by 140 basis points.

Learn more about S&P Capital IQ research and rankings on the above mentioned mutual funds. 

Follow Todd on Twitter at @ToddSPCAPIQ

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