We’ve built our asset allocation strategies for clients based on some powerful ideas backed up by undeniable evidentiary truths.
One of these truths is that the single biggest predictor of a fund’s success or failure can be found in how much it costs. Manager due diligence, fund family brand, PM pedigree, analyst tenure, strategic quirks, “boots on the ground”, rankings and ratings – all of these things may be important, but they pale in comparison to a simple analysis of how much a fund costs. This is not a matter of opinion, it is a quantitative matter of fact.
Don’t take my word for it, get it straight from the horse’s mouth.
Morningstar’s Russel Kinnel just re-ran the firm’s test to see which attributes of a fund were the best predictors of investor success in the long-term (the only term that matters). Morningstar is telling you, emphatically, that costs even trump the firm’s proprietary star rankings system. What else do you need to know?
The Answer: Costs Really Are Good Predictors of Success
We’ve done this over many years and many fund types, and expense ratios consistently show predictive power.Using expense ratios to choose funds helped in every asset class and in every quintile from 2010 to 2015. For example, in U.S. equity funds, the cheapest quintile had a total-return success rate of 62% compared with 48% for the second-cheapest quintile, then 39% for the middle quintile, 30% for the second-priciest quintile, and 20% for the priciest quintile. So, the cheaper the quintile, the better your chances. All told, cheapest-quintile funds were 3 times as likely to succeed as the priciest quintile.
Morningstar’s study, based on an analysis that’s been updated with numbers through the end of 2015, is today’s must-read for advisors, investors and other allocators of assets trying to do the right thing.
Investing is not a certainty game, it’s probabilistic. Are there ultra-expensive funds that can buck the research and outperform over the long-term? Perhaps, but this is an extremely low-probability bet. Could you have a portfolio of lower-cost funds and still underperform all of your peers? Again, it’s possible, but very low-probability according to the evidence assembled by Morningstar and hundreds of other research firms and academic papers.
Is that where you want to find yourself – betting on a fat-tail outcome when it’s entirely unnecessary? Not me.