In a recent Morningstar study, they found that mutual funds with lower management expense ratios (MERs) tended to outperform the returns of their higher cost peer mutual funds.
Another recent Morningstar study found that Canadian investors pay the highest mutual fund fees and expenses in the world, compared to 21 other countries included in the report. As shown in the chart below, the annual cost of owning a global balanced mutual fund can be extremely high, with an average MER of 2.22%.
In the pages of Berkshire’s 2010 Letter to Shareholders, Warren Buffett doesn’t seem to think so, as he agrees with Ray DeVoe’s observation regarding investment yield:
How are portfolio managers able to obtain higher fixed income yields (relative to a benchmark, such as the DEX Universe Bond Index) in this low interest rate environment? Dimensional Fund Advisors (DFA), a mutual fund company with Canadian operations in Vancouver, BC, would argue that markets are efficient; no investor can expect greater returns without bearing greater risk.
DFA’s fixed income investment philosophy focuses on two risk factors that have historically been shown to increase returns over the long term:
1. Maturity Risk – Longer term bonds are riskier than shorter term bonds
2. Default Risk – Bonds with lower credit ratings are riskier than bonds with higher credit ratings
By comparing a bond fund to an appropriate benchmark, an investor can gain a better understanding of the maturity and default risks that the portfolio manager is taking on.
In Chart 1.1 below, the maturity breakdown for the RBC Bond Fund is compared to the iShares DEX Universe Bond Fund (the closest investable proxy to the DEX Universe Bond Index). As can be seen, the RBC Bond Fund has underweighted shorter term bonds in favour of medium term and longer term bonds, relative to the iShares DEX Universe Bond Fund (increasing the fund’s maturity risk).
In Chart 1.2 below, the credit quality breakdown shows the RBC Bond Fund underweighting the highest quality bonds in favour of lower quality bonds, including a 6.1% allocation to high yield “junk” bonds, relative to the iShares DEX Universe Bond Fund (increasing the fund’s default risk).
The increased maturity and default risk in the RBC Bond Fund resulted in lower relative returns in the market downturn of 2008, but higher returns in the market recovery of 2009 and 2010 (see Chart 1.3 below).
For investors reaching for those higher yields (and willing to accept the increased risk), overweighting bonds with longer term maturities and lower credit qualities may be appropriate. However, for investors (like Buffett) who choose to take most of their risk in equities, they should consider investing their fixed income in shorter term, higher quality bonds (and sleep better at night).