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Study linking mutual fund fees and returns presents dilemma for investors

by Wayne Cheveldayoff, 2004-07-15

The old saying “you get what you pay for” apparently doesn’t work all the time for mutual funds. In fact, according to a study by an Edmonton analyst, the opposite occurs most of the time.

The study shows that, while there are always exceptions, mutual funds with high management expense ratios (MERs) produce lower final returns on average for investors than comparable mutual funds with lower MERs.

Surprisingly, the study shows a distinct negative relationship – meaning the higher the MER, the lower the return.

This presents a dilemma for investors, who are usually counseled by investment advisors that the final post-fee return is what they should be looking at, rather than the level of MER, and high MERs are the price one has to pay for good fund managers.

What should one do now? Should investors be looking to populate their portfolios with low-MER funds? After all, the study’s conclusions imply that low-MER funds will give better returns on average over time.

At the very least, investors with high-MER funds in their portfolios should initiate a review with their investment advisors to ensure that they have the “exceptions” producing great returns and that they really are getting what they are paying for.

The study was conducted by Gene Hochachka, who holds a Master of Science in Finance from the University of British Columbia. For eight years up to June 4, 2004, he honed his skills as a quantitative analyst with Phillips, Hager and North Investment Management of Vancouver.

Mr. Hochachka recently moved back to his hometown of Edmonton to be close to family and, with time on his hands until he takes on another job, he decided to publicize the findings of his study, which was previously conducted in his spare time with data sources he paid for himself.

While his study has not yet been printed in a journal where it could be reviewed by the industry and finance academics, Mr. Hochachka is making it available to the media and others who wish to see it (he can be contacted at

He said he has encountered a lack of awareness generally about MERs and their impact as no studies have been done in Canada, even though similar studies have been published in the United States. A 1997 U.S. study found that for U.S. equity funds from 1963 to 1993 a higher MER by 1 per cent would lower returns by 1.54 per cent.

For his Canadian study, Mr. Hochachka included data for every Canadian mutual and segregated fund that had all of total assets, calendar-year return and MER available at the end of any year from 1986 through 2003. It included funds that were subsequently merged into other funds or dissolved, “and thus it is not subject to the survivorship bias that tends to mar many studies of historical performance.”

He included those denominated in Canadian dollars and classified as Canadian balanced, dividend, equity, fixed income and money market funds along with international (global) and U.S. equity funds. The final sample included 20,130 fund years for the one-year comparison, 12,625 for the three-year, and 7,842 for the five-year. He used several different analytical techniques but, since they all showed the same thing, presented the findings of only the “robust regression” method.

Mr. Hochachka found that on average higher MERs “have a negative effect on returns in each of the seven major fund categories examined over the 1986-2003 period….Not only do expenses negatively affect returns, but they appear to affect them on nearly a one-to-one basis.”

In other words, if the MER is a full percentage point higher than a comparable fund, then it would tend to produce a final return (after MER is deducted) to the investor that is one percentage point lower than the final return of a comparable fund.

He also found that this tendency becomes even stronger as the return horizon increase to three and five years.

To ensure that his conclusions were not being driven by small funds whose scale-inefficiencies result in higher MERs, he re-ran the analysis for large funds only, which comprised 95 per cent of each categories assets, and by doing so eliminated half of the funds from the sample. “The results are slightly weaker but qualitatively similar to those for the sample as a whole: particularly for longer holding periods, the negative relationship between MERs and returns is not confined to the ‘small fry’ of the mutual fund world but also holds for their larger brethren.”

In making his conclusions, he emphasized that his analysis shows averages and tendencies. “This is not to say that all low-MER funds outperform all high-MER funds at all times: Just as many smokers die at a ripe old age of natural causes, some high-MER funds exhibit top-quartile performance despite their cost disadvantage. But just as smoking increases the probability of contracting lung disease, our evidence show that a high MER increases the probability of under performing other funds in the same category.”

His work left him with some fairly strong opinions related to buy and hold investing. “Finally, the irony that our results become stronger as the holding period becomes longer is not lost on us. The long-term, buy and hold investor for whom investment funds are designed and to whom they are marketed is also the person most harmed as high expenses exact their inevitable toll on long-term performance,” he stated.
“Even more than the month-to-month performance chaser, the long-term buy and hold investor is best served by eschewing higher-MER funds in favour of their lower-MER peers.”

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2004 Wayne Cheveldayoff