Cheaper Is Not Better: On the ‘Superior’ Performance of High-Fee Mutual Funds

Abstract

In contrast with theoretical predictions, after-fee performance of actively managed equity mutual funds is known to decline with expense ratios. We show that this relation is entirely driven by the preference of high-fee funds for stocks with low operating profitability and high investment rates, characteristics associated with low expected returns. After controlling for exposures to profitability and investment factors, high-fee funds significantly outperform low-fee funds before expenses and perform similarly after expenses. Our results have important implications for asset allocation decisions and support the theoretical prediction that skilled managers extract rents by charging high fees.

Keywords: Mutual fund performance, fee-performance relation, factor models, valuation cost

JEL Classification: G23, G11, J24