Expense Ratios as Predictors of Mutual Fund Performance
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A recent study by Morningstar has provided support for something that many of us have long believed to be true… When it comes to investment performance, cost matters. A lot.
In fact, looking across the past five years, low fees are perhaps the best predictor of future mutual fund performance – even better than Morningstar’s own star rating system. This isn’t to say that Morningstar’s ratings are without merit, as higher rated funds do typically outperform lower rated funds.
In comparing expense ratios and star ratings, Morningstar thus concluded that both were helpful. However, looking at expense ratio alone resulted in better results more often (58% of the time) as compared to looking at star ratings alone.
So, what did Morningstar learn from all of this?
“Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you’ll be on the path to success.”
The study’s author went on to say that:
“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”
More often than not, this means you should focus on index mutual funds and ETFs, as their expense ratios are typically the lowest. Of course, as Morningstar also points out, you also need to be sure that you understand the funds management and goals before investing.
This result shouldn’t really come as a surprise, as most mutual funds with similar goals have similar holdings (yes, I’m generalizing here). Thus, if one fund charges significantly more than another, its performance will ultimately be lower.
Source: Morningstar.com
Published on August 23rd, 2010 - 5 Comments
Filed under: Saving & Investing
About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!
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August 24th, 2010 at 3:07 pm
This is an intertesting, but incomplete post. While it is true that funds with lower expenses out perform funds with higher expenses, why would you want to put money in mutual funds at all?
Over the last twenty years the DALBAR Quantitative Analysis of Investor Behavior reports that the average domestic equity fund investor has earned only 3.17%. And that is before taxes!
Investors should instead use a defined rule set to select their portfolios of individual stocks. This is an efficient, effective and tax wise solution that avoids all the draw backs off mutual funds.
August 24th, 2010 at 4:48 pm
I prefer ETFs mixed with some handpicked individual stocks/bonds. The strategy obviously depends on the tax implications of the investment account among other factors.
August 24th, 2010 at 7:34 pm
Would have been interesting to see what the results were for actively managed funds, but good information nonetheless.
August 25th, 2010 at 7:08 am
I agree with Robert,why do you want to keep investing in mutual funds at all? Over the last 20 years are these fund professionals that great? Its a joke really.
I also like individual stocks and EFTs however, you also should consider diversification outside the market. Think outside the box – rental houses, farm income, annuities. Things that are going to provide you with recurring revenue.
August 27th, 2010 at 3:33 pm
Couldn’t agree more with this. Anytime I invest in a fund I check what the expense ratio is. None of the funds I have invested in have expenses higher than 1% and most are much lower than that. Thanks to bloggers like you that have confirmed this for me!