Why Lower-cost Funds May Be Overvalued

By Twickenham Advisors on June 8, 2018

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. – Warren Buffett

Lately, it seems many investors are very fee conscience when it comes to mutual funds, hedge funds, ETFs and financial advisors. With the miracle of compound interest at work, fee-consciousness makes sense. Just saving half a percent on fees every year is much more meaningful after 10 or 20 years of compounding returns (or losses). I would rather drink orange juice after brushing my teeth than pay an unnecessary 25 basis points in fees per year.

The attitude towards fees typically increases after financial crises and tends to fade into the background as markets move up. The sentiment moves in cycles but is frequently the subject of conversations. I was reading a book from 1992 the other day about mutual fund investing, Straight Talk About Mutual Funds, and I came across this line, “Because investors have become so load-conscious and the mutual fund industry so competitive, high-load funds are getting scarcer.”

An argument that has seemed to prevail in the past few years is that index funds are the way to go now because for the lowest fees in the market, you get the same performance or better than higher cost, actively managed funds. I would agree with this thought for the most part. Most higher-cost actively managed funds are merely mimicking the index anyways. Bill Miller, the famous fund manager, recently said that he estimates over 70% of actively managed funds are actively managed in name only. As an active manager himself, he agrees that for the most part, higher-cost funds are not worth their salt.

But consider the fact that a fund’s expense ratio is not the only price you are paying for a fund. Yes, the Vanguard S&P 500 index ETF (VOO) has an expense ratio of .04%. This is about as cheap as they get in the fund world and the performance is right in line with the S&P 500. But you aren’t really owning a fund. You are really owning shares of a basket of companies selected and weighted to mimic corporate America. And some of these companies aren’t cheap. In fact, because the S&P 500 is market cap weighted, the index has a momentum tilt that adds more money to the biggest companies thus making them even more expensive over time. After everyone piles in (arguably now), the heavier weighted stocks in the index tend to revert to average prices.

Indeed, in the Vanguard S&P 500 index ETF (VOO), you are paying $16.85 for every dollar of earnings, $2.86 for every dollar of book value and $2.13 for every dollar of revenue. All else equal, wouldn’t you rather pay a 1% expense ratio and get a dollar of earnings for $12? Or get a dollar of book value for $0.9? Or a dollar of revenue for $1.10? Wouldn’t you gladly pay higher fees if that meant higher returns or same returns but with lower risk?

At Hightower Twickenham, we consider the cost of the funds and strategies we employ very carefully. But, we are also careful to optimize a strategy’s expense with its fundamental merits. If you’d like to talk to us more about how we select investments, funds, ETFs, etc. please feel free to reach out to me via email or phone.

JGibson@hightoweradvisors.com | 256.213.1150