Low Expenses are the Rosetta Stone of Fund Investing

If there’s one thing that Morningstar is criticized for (over and over), it’s their 1-to-5 star ranking system.  it is routinely bashed for being a performance-chasing, backward-looking measure of how funds have done and rarely a predictor of future success.  I agree and disagree with that – but it’s complicated and I don’t want to get off track here.

This article appeared a couple of years back and I’ve read things that subsequently referenced it, but I’m first getting through it now and I think there’s a timelessness to this concept.

So forget about the stars for a moment, this is way more interesting (and exciting if you’ve been stuck in a rut, portfolio-wise)…Russel Kinnel and his team ran a slew of numbers on their universe and ratings from 2005 through 2010 based on three factors – their star system, success ratio, and expenses.  It turns out that the magic answer investors have long sought when choosing funds is the very simplest one, right under their noses all along:  Low expenses are the only predictor of outperformance of any statistical significance.

Check this out…

From Morningstar (emphasis mine):

How Expense Ratios Performed
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. To see the results, click here.

Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.

For example, the cheapest quintile from 2005 in domestic equity returned an annualized 3.35% versus 2.02% for the most expensive quintile over the ensuing five years. The gap was similar in other categories such as taxable bond, where cheap funds returned 5.11% versus 3.82% for pricey funds. That same relationship held up dependably in the other time periods we measured. For 2008, the cheapest quintile of balanced funds lost 0.04% over the next two years, while the most expensive shed 1.13%.

The gap was also impressive as measured by the success ratio because high-cost funds are much more likely to have poor performance and be liquidated or merged away. For the 2005 group, we found that 48% of domestic-equity funds in the cheapest quintile survived and outperformed versus 24% in the priciest quintile. Put another way, funds in the cheapest quintile of domestic equity were twice as likely to succeed as those in the priciest quintile. It was a similar story in other categories, although in munis the advantage was greater than 6 to 1. The same basic relationship held up for the other years we looked at. Although I think of expense advantages as taking a long time to compound to your advantage, even the 2008 group saw low-cost funds with nearly a 2 to 1 success advantage.

Given that performance edge, you won’t be surprised to hear that low-cost funds also produced better risk- and load-adjusted performance as measured by the star rating. For example, the 2005 group enjoyed a subsequent 3.23 average star rating compared with 2.66 for the priciest quintile in domestic equity. The edge grew in taxable bonds to 3.34 versus 2.3. The edge held up for predicting three-year ratings for the 2006 and 2007 groups.

The rest of the study and findings are at the link below, but I regard this as Case Closed.  Cheaper is better, all things being equal.  At my shop, when we’re building and managing models, we are constantly on the lookout for ways to lower internal costs of products – if that means swapping an active manager for a passive one, so be it, if that means going I-class mutual fund to ETF, too bad.  It seemed instinctive to us that this was the best course, it’s good to have data to back that up.

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