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.