Investors have poured money into index funds, because actively managed mutual funds have failed to beat passive strategies over long periods of time. But a new study shows that higher fees on active funds have also deterred investors from opting for a fund that seeks to outperform the market.
It costs far more for investors to put money to work in active strategies compared to index funds. It was previously unclear, however, whether the higher fees have decreased investors' appetite for active.
Researchers at the Norwegian School of Economics, including Trond Døskeland, Andre Sjuve, and Andreas Ørpetveit, attempt to answer that question in a a paper entitled "Do Fees Matter? Investor's Sensitivity to Active Management Fees."
When fees rise, actively managed funds face a decrease in net flows. The authors find that a one standard deviation increase in a fund’s fee results in a decrease in net flows of roughly .23 percent.
The researchers used data from Lipper and Morningstar Direct to create a sample of 10,814 funds, which they analyzed on the basis of fees, flows, and Morningstar ratings, among other measures.
What sets their research apart from peers, according to the paper, is that they chose to examine the extra cost of active management, rather than total fees. They refer to this measure as the “excess fee,” which is the cost beyond using a passively managed benchmark strategy as a substitute.
In addition to this finding, the researchers evaluated the types, size, and strategies of the actively managed mutual funds. They found that investors in high-rated funds (using Morningstar’s rating system) tended to be more sensitive to fees. “Investors in funds with high ratings are more rational, following the fee-signals to a larger extent,” the researchers said.
Investors are less sensitive to fees when they have invested in high-performing strategies, regardless of the rating.
The researchers also found that the size of the fund doesn't matter when it comes to fee sensitivity, but that fund strategy does. For example, investors are more sensitive to fees with value funds than growth funds.
“We demonstrate that in a market where it is hard for both researchers and investors to identify what creates value for the investors, at least some investors use a ‘rational’ signal such as active fee,” the researchers said.
Both researchers and investors could use this information to their advantage.
“The fee variables are decided ex-ante by the funds themselves and are not decided based on historical performance by an external agency,” they wrote. “We therefore argue that fee variables are more informative of future performance than Morningstar ratings, and that active mutual fund investors should therefore have responded more than they were shown to do.”
