This post illustrates the impact of costs on returns for Larger-Cap U.S. Equity Funds on a pre-tax basis for the period 1992 - 2006
Using the CRSP Survivor-Bias-Free US Mutual Fund Database, we examine general larger-cap equity funds1 starting on December 31, 1992. We follow the funds through December 31, 2006 and calculate average expense ratio, average turnover and average annualized return (geometric mean) for all funds from the original sample that are still listed at the end of the period.
Basic Facts
There were 842 funds in original sample, of which 450 funds survived to the end of 2006 (we call these surviving funds)
The remaining 392 funds from the original sample were either liquidated or merged with another fund before the end of the period (we call these dropout funds)
The median average annualized return for surviving funds was 9.74%
A regression analysis shows that among surviving funds, a 1% increase in expense ratio corresponds with a 1.39% reduction in average annual return, and that a 100% increase in turnover ratio is associated with a 1.49% reduction in average annual return.2 (Dropout funds had lower returns, higher expense ratios and higher turnover than surviving funds)
Illustrations
Figure (1) plots all of the surviving funds by its average expense ratio over the 14 year period (x-axis) and its average turnover ratio over the period (y-axis). Blue dots represent funds that had above median returns for the period, and red dots represent funds that had below median returns. The larger the blue (red) dot, the higher (lower) the fund's return.
Notice how the lower left corner, corresponding to the funds with both the 20% lowest expenses AND the 20% lowest turnover, is mostly filled with blue dots, with only a few small red dots. At the other extreme, the upper right corner, with the funds in the 20% highest expenses AND the 20% highest turnover, is mostly composed of larger red dots. (Any fund with turnover > 400% or expense ratio > 4% is displayed at the margin). This is a quick visual indicator of the different probabilities of success for lower and higher cost funds.
Figure (2) plots, for each surviving fund, what a $1 investment on Dec. 31 1992 would have been worth on Dec. 31, 2006 (y-axis) and the fund's average expense ratio for the period (x-axis). The large green dots plot the median expense ratio vs. median value for each decile of funds, sorted by expense ratio.
The median final value for the lowest-expense decile (average expense ratio < 0.62%) was $4.15. The median final value for the highest expense decile (average expense ratio > 1.75%) was $2.76. So at the end of the period, the average low-expense fund was worth 1.51 times more than the average high-expense fund.
Figure (3) plots both the surviving and dropout funds by average expense ratio. The blue dots represent the surviving funds, where the x-axis position is the average expense ratio for the period, and the y-axis shows the fund's excess return for the period (i.e. the difference between the funds' average annualized return and the median of average annualized returns for all surviving funds). This blue and green dots are similar to Figure (2) above, except in this graph the y-axis value is the average annualized return and not the final value. The red dots represent the dropout funds, where the x-axis value is average expense ratio through the last full year that the fund was in existence. The y-axis value is the fund's excess return relative to all of the funds that had survived through the last full year that the fund was in existence for that period(e.g. if the fund dropped out in April 2000, we take its average expense ratio and excess return relative to other funds as of December 31, 1999).
The placement of red and blue dots is a visual illustration that the funds which dropped out of the sample before the end of the period had disproportionately lower returns, higher expenses and higher turnover than the funds which survived the entire period. The big green decile dots show that the lowest-expense decile had a median average annualized return of +10.71% while the highest-expense decile had a median average annualized return of +7.52%.
Figure (4) is similar to Figure (3), except that the x-axis represents the average turnover, instead of average expense ratio.
The lowest-turnover decile (average turnover ratio < 14%) had a median average annualized return of +10.67%, while the highest-turnover decile (average turnover > 146%)had a median average annualized return of 8.55%. If we do a similar calculation to the one in Figure (2) and calculate final values by turnover deciles, we find that the lowest-turnover decile median final value was $4.13 vs. $3.15 for the highest turnover decile. So at the end of the period, the average low-turnover fund was worth 1.31 times more than the average high-turnover fund.
And for the last 5 years
The above analysis is for the period of 1992 - 2006. If we perform a similar analysis on the same class of funds for the most recent 5-year period (December 31, 2001 - December 31, 2006) we get slightly different, but qualitatively similar numbers:
3,364 funds in the initial sample, of which 2,175 survived the entire 5 years, and 1,189 dropped out before the end of the period.
The median average annualized return of surviving funds was 5.68%
A regression analysis shows that among surviving funds, a 1% increase in expense ratio corresponds with a 1.03% reduction in average annual return, and that a 100% increase in turnover ratio is associated with a 0.75% reduction in average annual return.3 (Again, dropout funds had lower returns, higher expense ratios and higher turnover than surviving funds)
Ranking funds by expense and turnover and looking at the median performance of the deciles, shows that the lowest-expense decile had median average annualized return of +6.04% and a median final value of $1.34, vs. +3.44% and $1.18 for the highest expense decile. Likewise, the lowest-turnover decile had median average annualized return of +5.92% and a median final value of $1.33, vs. +4.64% and $1.25 for the highest turnover decile.
1 Funds identified with Standards & Poors Objectives "Equity USA Aggressive Growth", "Equity USA Growth" and "Equity USA Growth & Income" . We choose to start the analysis on December 31, 1992 as it is the earliest date when the Standard & Poors objective classification codes appears in the database)
2 The regression equation is
y = -1.3909*expense + -0.0149*turnover + 0.1244 (R2 = 0.58)
3 The regression equation is
y = -1.0268*expense + -0.0075*turnover + 0.0755 (R2 = 0.15)