The More You Know, The Better You Do

Investors have been gravitating towards low expense ratio mutual funds and exchange-traded funds (ETFs) for many years, which is smart.  All things being equal, lower expense ratios mean higher returns.  But things are rarely equal, and there's a lot more than low expenses to achieving a successful investment experience.

Consider the chart above.  It graphs the growth of $10k since April 2005 (VWO inception) in the iShares Emerging Markets Index (EEM) and the Vanguard Emerging Markets Index (VWO), both ETFs.  You might expect a wider margin after 13 years because the former has an annual expense ratio of 0.69% and the latter just 0.14%.  But small differences in index construction cancel out the expense ratio differences, and their returns are only 0.06% a year apart (in favor of Vanguard).  That's pure noise.

Now, you might say, 0.06% isn't 0.00%, and on $10,000 that meant $185 difference in total wealth.  I hope you wouldn't say that, but I realize you might be thinking it.  So let's instead address a much more important consideration than basis points in investment expenses: investor behavior.

Morningstar tells us, over the last 10 years, the annualized investment return of the Vanguard Emerging Markets Index Fund* was +1.5% per year.  But investors on average didn't even earn that return.  They tended to buy emerging markets after a strong run, and sell them after they dropped or underperformed US stocks.  Emerging markets are the most volatile asset class so performance chasing is particularly acute in this category.  The result of this bad behavior?  Vanguard Emerging Market Index Fund investors actually lost -3.9% per year on average.  Left to their own devices, they underperformed their fund by 5.4% per year!  This is 10x the difference in annual expenses between the iShares ETF and Vanguard's lower cost version, and 38x greater than the Vanguard expense ratio.  Clearly, investment decisions, not just expense ratios, are a major factor.

But not all investors in emerging markets suffered the same fate.  Those who invest with Dimensional Fund Advisors (DFA) mutual funds tend to have a fee-only, independent Registered Investment Advisor (RIA) who has created an investment plan according to their long-term goals and acts as a fiduciary on their behalf, putting their best interests first.  This means that emerging markets are a strategic part of a big-picture plan, and most advisors explain in detail their volatility and occasionally disappointing returns which helps promote greater discipline.  It turns out, the more you know, the better you do.  

Over the last ten years, the DFA Emerging Markets Fund earned +2.8% per year, but investors in the fund did even better, returning +3.3% per year according to Morningstar.  To receive this return, investors had to buy low and sell high -- rebalance out of emerging markets after a hot streak and buy more when they were one of the worst performing asset classes!  This sounds easy, but most investors without an advisor are unable to pull this off and it costs them several percent a year in missed-out-on returns.  Said differently, focusing on small differences in expense ratios instead of an overall investment plan and disciplined management is costly.

To be sure I didn't inadvertently select a DFA emerging markets fund that had positive investor returns by chance, I looked up the biggest emerging markets fund that DFA manages measured by current assets, the Emerging Markets Core Equity Portfolio.  It turns out it was no fluke, DFCEX did even better -- +3.4%, and investors better still: +5.9% per year.  Investors in the DFA Emerging Markets Core Fund had actual investor returns as reported by Morningstar that were almost 10% a year (9.8%) better than Vanguard investors.

This is not to say expense ratios don't matter -- paying some active manager 2% a year to buy emerging markets stocks isn't a smart idea.  But at the low end of the expense spectrum, there are far more important considerations than expense ratios.  Portfolio design and construction, turnover, and investor behavior are good examples.  The more you pay attention to these inputs, the better you will do.  

*Morningstar doesn't report investor return data on ETFs, only mutual funds

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Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.