Last week, we told you about a paper that suggested price competition in the mutual fund industry was somewhat less than robust. Rather than lopping all mutual funds into one pot and comparing their fees, the authors of that report examined the fees of individual funds relative to their Morningstar category average. While not as ideal as examining the active management delivered by each fund, this approach loosely categorizes funds by their level of active management (e.g. the small cap growth category has a higher level of active management than the large cap value category).
Although not directly examined by that particular paper, one category that makes no denials about its lack of active management is the S&P Index Mutual Fund category. These (almost) purely passive funds are the subject of another paper by the same authors available here.
In “Institutional S&P 500 Index Mutual Funds as Financial Commodities: Fact or Fiction?” John Haslem, Kent Baker and David Smith examine whether index funds are really are all the same and whether they are truly “commodities”.
They find a wide variation in the fees (and therefore the performance) of S&P index funds. This is counter-intuitive given their common Investment strategy, but even more counterintuitive when one considers that institutional investors should be less likely than retail investors to pay unwarranted fees.
While the market for index funds isn’t homogenous, the researchers find that at least it’s a lot more competitive than other mutual fund categories.
It turns out that the price of an index fund has a lot more to do with the economics of managing a fund, not the investment strategy itself. For example, large funds and funds with small minimum investments tend to charge larger fees. Comment the authors:
“If institutional investors priced S&P 500 Index funds as commodities, they would be unlikely to continue to commit new money to chronically high-cost funds, while much lower cost alternatives existed. On the other hand, if these investors could not meet the minimum initial purchase of low-cost funds, their opportunity set would be restricted.”
Since the underlying investment strategy is exactly the same across this category of fund, any difference in fees should translate directly into lower returns. Not surprisingly, this is what the authors found.
So why on earth would you want to buy a fund that was virtually guaranteed to underperform? There are a number of reasons, say the authors:
“…investors in the institutional realm may value fund features beyond the expense ratio. For example, such investors may value the availability of a wide variety of funds including money market and other index funds offered by the family and the cost of these other funds…high-cost institutional index funds come from families that offer greater choice to investors, or that offer low cost funds elsewhere in the family…”
The growing interest in portable alpha and alpha/beta bifurcation will likely bring these funds into more direct competition with products such as index futures, swaps and ETFs. So it will be interesting to see if fee deviations like the ones described in this paper become more closely linked to tangible attributes. In other words, will there eventually be a base (commodity) fee and a Chinese menu of other attributes (low minimum, an option to switch to another fund in the same family etc.)