Morningstar Inc., one of the most well known mutual fund evaluation companies, published a study on August 9th that concluded low fees were the best predictor of a mutual fund’s future success – even better than Morningstar’s own star-rating system.
This is a big deal; because Morningstar’s business consists of looking at past returns of mutual funds using a complicated evaluation system, assigning a star-rating to each one, and selling this information to individual investors, libraries and the financial industry. Mutual fund companies take out full page ads touting their 5 star rating because they know it will attract new deposits. For years, financial magazines have instructed people to invest only in Morningstar 5-star ranked mutual funds if they wanted to own the “best performing” funds.
“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,” wrote Russel Kinnel, Morningstar director of fund research and the study’s author. This conclusion is very important, because many creators of hedge funds and active mutual funds acknowledge that they are much more expensive than other alternatives, but insist that their outperformance will overcome costs. Based on the study, in every single time period and data point tested, this was not the case. It is too difficult to overcome the burden of high costs.
The investment industry is required to remind people that past performance is no guarantee of future returns. I believe people are deaf to this warning because research shows mutual funds experience a flood of new deposits after they publish high returns, and they are usually severely disappointed with the results. A better tactic is to focus on what you CAN control – what you are paying to invest in the fund. Mr. Kinnel at Morningstar came to the same conclusion: “Perhaps the most compelling argument for expenses is that they worked every time–because costs always are deducted from returns regardless of the market environment. The star rating, as a reflection of past risk-adjusted performance, is more time-period dependent. Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.”
I couldn’t have said it any better myself.