Larry Cao of Morningstar discusses the role of fees as part of the investment decision-making process for mutual funds, including fee trends and considerations with US funds.

Date: May 2011

Tags: Fees, Mutual funds

• Ultimately, individual investors should make a judgment about fees on whether they feel they are getting adequately compensated in terms of returns
• The aim when trying to ensure value for fees is to understand what generated the performance in the past, to serve as the basis for assessing potential returns going forward
• Fees in general have got more competitive, in line with increasing competition locally and from overseas managers
• When investors buy US funds run out of the domestic market but marketed internationally, they pay higher fees but avoid some of the tax issues for non-US investors

While fees are important when looking at investing in mutual funds, what investors actually pay for is performance, said Larry Cao in an interview. This isn’t absolute performance, rather risk-adjusted performance.

If the fee is higher, the performance investors get from the managers might be less, he added. Yet if a manager delivers more performance to compensate for the higher fees, this should be acceptable to investors.

Ultimately, individual investors should make a judgment about whether they feel they are getting adequately compensated in terms of returns, said Cao.

That is difficult to judge, however, so investors tend to make buying decisions based solely on fees.

Getting value for money

According to Cao, the US$6 million question for investors is how they can ensure they are getting value for the fees they are paying.

Investment consultants such as Morningstar try to serve that role, he explained, by looking at the management of a fund from a qualitative perspective – in terms of understanding things such as the investment process and philosophy, and the background of the managers.

Consultants also take a quantitative point of view in terms of looking at performance versus peers, versus the benchmark and versus the fund’s own historical track record, he added.

Cao said the aim is to understand what generated the actual performance in the past, to serve as the basis for judging whether the particular manager can continue to generate the outperformance and justify their fee going forward.

Trends in mutual fund fees

Fees in general have got more competitive, said Cao. In some newer emerging markets, when investors see dramatic growth in the fund industry and performance is good, they don’t pay close attention to returns. However, he added, after a few market cycles, investors get more sophisticated and discerning about fees.

Plus, he added, there is increasing competition, both locally and in terms of overseas managers entering the markets.

Considerations with US funds

When investors buy US funds run out of the domestic market but marketed internationally, Cao said the fee level can be different from their US-based sister or cousin funds.

This is generally because of the different legal and accounting environments, so the fees have to satisfy additional regulatory and compliance issues. As a result, the funds charge more on the operational side.

But when investors buy these funds, they avoid some of the tax issues for non-US investors, said Cao.