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Thomas Macpherson
Thomas Macpherson
Articles (140)  | Author's Website |

Fund Performance Before and After Fees: Does It Matter?

Funds are increasingly underperforming both before fees are included as well as not included in their return calculation

January 31, 2019

Sometimes we get things all wrong with muddle-headed thinking. What if we accepted as a fact that regardless of management fees, or turnover rates, or 12b fees, investment managers in general sucked at choosing the best investments – bonds, equities, lumber, hogs, or even corn for heaven’s sake. What if from the beginning, most human beings not be allowed anywhere near a trading exchange – stock, commodities, etc. – under penalty of death? Would the average middle-American investor be better off?”   - Ed Meehan

In my book - “Seeking Wisdom: Thoughts on Value Investing” - one of the major topics I discuss is the impact of fees and their role in underperformance for many mutual funds and investment managers. As I mention, fees are remarkably corrosive, constantly eating at total returns and doing great harm to investors’ long-term investment performance. Fees are like some kind of enormous leech sucking the blood out of investors’ returns.

Since writing the book, there have been three additional data points that have added to – and in some cases wholly changed - the basis of my theories. First, management fees have generally continued coming down (see my article[1] on management fees) The second data point – somewhat contradicting my initial theories – is that bringing down fees doesn’t necessarily mean better performance against a fund’s proxy. The third point – which really rocked my thinking is that funds - before any fees have been applied – have been increasingly underperforming their proxy. In a recent article in Morningstar[2], Jeffrey Ptak points out the fact that since 1997, mutual funds (before fees) are finding it increasingly difficult to outperform in general. In his article, he laid out three major findings from his research.

  1. Before fees are assessed, funds are outperforming less often and also by smaller margins.
  2. Across the board, styles such as value-growth and large-small are performing more alike than ever before.
  3. The styles you wouldn’t expect to outperform (large-cap and growth) are leading.

At first blush, it’s a very interesting dilemma. Mutual funds are increasingly underperforming their proxy (regardless of size or style) both before and after fees are assessed. Let’s start with mutual funds prior to management applying the management fee.

In Ptak’s paper, he reviews active management returns versus passive investing returns over five-year rolling periods from 1997 to 2018. As seen in the graphic below, the trend has been downward since 1997. It isn’t a very steady decline – with lots of pops and drops, but it is unmistakable that after fees, the ability for active management to beat passive indexing is getting weaker over time. After peaking in the years directly after the tech bubble, when nearly one-half of active managers outperformed index funds, that number has dropped to less than one in five by 2018. Interestingly, after both the 1999-2000 tech bubble and the 2006-07 credit bubble, active management outperformance jumped but then continued its descent.

Here are the same numbers after fees are assessed.

As we can see, Ptak has done a great job showing the increasing amount of mutual fund underperformance proportionally changes but has seemingly little – or no relation – to the amount or percent the mutual fund company charges as a management fee.

Let's then take a look at data from the Investment Company Institute. As seen in the figure below, management fees have been steadily dropping since 1996. Even as an increasing amount of mutual funds underperform, management fees continue to drop. In 2017 (the latest data available), average annual expense ratios for equity mutual funds fell four basis points to 0.59% from 0.63%. Average hybrid and bond mutual fund expense ratios declined three basis points from their values in 2016 to 0.7% and 0.48% [1].

Longer term, the average expense ratio of actively managed equity mutual funds fell to 0.78% in 2017, down from 1.08% in 1996. Index equity mutual fund expense ratios fell to 0.09% in 2017 from 0.27% in 1996. ICI reports that investor interest in lower-cost equity mutual funds - both actively managed and indexed - has fueled this trend, as has asset growth and resulting economies of scale.

For the “after fee” performance record, we have to look at the S&P Dow Jones SPIVA US Year-End 2017 [1] report, which looks at mutual fund out and underperformance versus the S&P 500 (they have reports on Asia, Europe, etc. as well). The report shows that over the 15-year investment horizon (2002 to 2017), 92.33% of large-cap managers, 94.81% of mid-cap managers and 95.73% of small-cap managers failed to outperform on a relative basis. In other words, over the last 15 years, only one in 13 large-cap managers, only one in 19 mid-cap managers and one in 23 small-cap managers were able to outperform their benchmark index after fees.

It seems the data can show us three trends that can be vital as you think about adding some active management funds or advisors to your investment management strategy.

Active management does better in declining, crisis-driven bear markets

As you can see from the chart above, active management outperformance increases when markets are dropping for any host of reasons. After both the technology bubble in 2000 and the credit bubble in 2006 ended in extreme drawdowns, active management (both before and after fees) increased outperformance by roughly 63% during the ensuing bear markets compared to the previous bull market.

Conversely, active management does worse in bull markets

It wouldn’t be a proper analysis without inverting the argument. During long bull markets, active management (both before and after fees) has a proclivity to badly underperform passive indexing. Just ask many investment managers how they did against their respective proxy from 2011 to 2017. It’s generally a grim story with many excuses. I certainly include myself in this category.

Decreasing fees (or no fees) isn’t enough, underperformance is still growing

Perhaps the most striking finding from recent research is that underperformance is increasing even before fees are applied or when fees are decreasing. One would think that all things being equal, if I were to drop my fees (or measure without my fees at all) as an investment manager, I would increase my odds at outperforming my proxy. The reality is the exact opposite. So what’s driving this strange dichotomy? Obviously all things – after all - are not equal. There is an additional force at play that needs greater research to explain this increasing underperformance.


I use to think some things in the investment world are relatively cut and dry. Value beats growth over the long term. Higher fee funds underperform lower fee funds. Reducing fees increases your chance at beating your respective proxy. But the case of high fees (or fees at all) being a determinant in underperformance is extremely flawed in theory – and seemingly in practice. Over the next several months, it is my intention to roll up my sleeves and further research the question raised in the last paragraph of the previous section – why fund underperformance is growing regardless of fees.

Until then, I look forward to your thoughts and comments.

Disclosure: None

[1] “Average Expense Ratios for Long-Term Mutual Funds Continued to Decrease in 2016":, Investment Company Institute, Morris Mitler and Sean Collins, May 23, 2017

[2] https://www.gurufocus.com/news/333004

[3] “The Active Stock Fund Slump Explained”. Jeffrey Ptak, CFA 15 Jan. 2019 https://tinyurl.com/y9kccrb6

[4] The actual report can be found at https://tinyurl.com/y939tz7m

About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website

Rating: 5.0/5 (3 votes)



Robert Abbott
Robert Abbott premium member - 1 month ago

Just a bit of wild speculation here, but could there be something about the proxies that has changed (if nothing is obvious on the fund manager side)? Bob

Thomas Macpherson
Thomas Macpherson premium member - 1 month ago

Hi Bob. It's an interesting question. I think a lot more research needs to go into the findings. Whatever the cause, the message for active managers is sobering. Best - Tom

Stephenbaker - 1 month ago    Report SPAM

Why is it striking that outperformance is declining along with fees? Why should anyone pay for underperformance? Perhaps with lower fees comes less interest from qualified investment individuals. More and speedier information available to the masses may level the playing field. So much has been written about investing that nothing any more seems new; when was the last time you read a book or article offering anything but recycled information about investing? On the flip side, the "proxy" has become a near cost-free, perfect alternative to active management (thanks, Jack Bogle). For all intent and purpose, the SPY is a well-diversified, global list of companies based in the friendliest country in the world for doing business. The index's holdings are always replaced with new holdings when a company's market cap suffers a serious decline so the index never experiences a total loss of one of its holdings. Investors get all of the upside and do not assume the risk of all of the downside. Though this may seem trivial, how many funds ride investments down to near -0-? In the retail sector alone, I can think of a handful of such companies just in the past year or two. Think energy several years before that. Not to mention biotech, tech and a laundry list of ".coms" from the early 2000s. Personally, I think most people that don't know enough to properly monitor their investments and investment professional(s) would be better off with proxies. The growth of index investing (including ETFs) seems to suggest that is indeed the case.

Thomas Macpherson
Thomas Macpherson premium member - 1 month ago

Hi Stephen. Thanks for your comment. I agree with nearly everything you say. However, I should stress the study discussed underperformance is increasing BEFORE fees are applied. The vast majority of your "recycled information" as you mention is based on comparing funds (less fees) versus index/passive investing. There actually hasn't been much written about performance before fees. There is no doubt active management does better in bear markets. Your point about actve funds riding down to zero doesn't reflect that active managers handily beat index funds in bear markets when such funds supoosedly ride stocks down when index funds do not. If this is the case, and the data show it clearly, then your comment "the index's holdings are always replaced with new holdings when a company's market cap suffers a serious decline so the index never experiences a total loss of one of its holdings. Investors get all of the upside and do not assume the risk of all of the downside". doesn't quite wash. I think the answer as to why active funds - before and after fees - outperform in bear markets but generally underperform in all markets is more complex than our original relatively simplistic theses. I say this with much respect by the way and in no way want this to come across as dismissive of your response. Best - Tom

Stephenbaker - 1 month ago    Report SPAM

Tom, by definition bear markets mean a decline in price. Indices don't realign based on price (other than when stocks drop out). You would expect professional investors to do better during bear markets because that is when bargains show up. When you go shopping do you get more for your money when the items you are buying are on sale?

I understand your point about underperformance before fees but my point is that there are almost no fees associated with indices so like you, I don't think that fees are the issue, other than to the extent that less fees attracts less (and less qualified) investment professionals to the business. Also, in selecting stocks for an actively managed fund, it is ironic that success often breeds failiure. Certain funds only invest in companies of a certain size. Smaller cap managers sell successful holdings when they outgrow size parameters. Funds that invest in select industries suffer when the industry is down or when holdings no longer engage in a target business. The law of large numbers often catches up to successful money managers who can more profitably invest smaller sums. It would be interesting to go back and view the success of funds prior to, and after closing to new investors (I don't think the results will be surprising). Likewise, how often do fund managers find they must go outside their scope of competency due to competition, poor performance, restrictions on what they can or can't invest in, economic factors, or nearly any other factor that creates a feeling of urgency to outperform? I am not surprised at all that active funds underperform. The greatest investor ever has a tough time outperforming these days and he can invest in literally anything.

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