Wouldn’t it be great to find a silver bullet, that one piece of information that helped predict the future performance of an investment? While not a silver bullet, a recent study by Morningstar suggests there is a best predictor of future mutual fund performance: the expense ratio.
Each year investors and investment advisors scour mutual fund total return tables and various ratings schemes to find the best funds. Morningstar is an investment research firm that aims to help in this process and is famous for its “star” ratings system. For mutual funds, Morningstar assigns a rating of one to five stars for various time periods based upon risk-adjusted performance. Five star rating is best; one star is worst.
Morningstar’s study focused on their own ratings system, highest-cost versus lowest-cost funds, and success ratio. Since mutual fund families often quickly close poor-performing funds, the success ratio tracks the percent of funds in a group that survived and outperformed peers. This ratio determines whether each measure, ratings or expense ratio, helped avoid steering investors into failed funds.
The study looked at star ratings and expense ratios from 2005 through 2008 and tracked performance through March of 2010. Funds were grouped into five broad categories: Domestic Equity, International Equity, Balanced, Taxable Fixed Income, and Municipal Bond.
Some of the key findings include:
• Expense ratios are the strongest predictors of performance. In every single time period and data point tested, low-cost funds beat high-cost funds.
• High-cost funds are much more likely to have poor performance and be liquidated or merged away. Funds in the cheapest quintile of domestic equity were twice as likely to succeed as those in the priciest quintile. The cheapest municipal bond funds had a 6-to-1 advantage over the priciest.
• Five-star funds beat 1-star funds in 84% of observations. Five-star international funds that survived lagged 1-star funds that survived.
• Morningstar ratings were effective in guiding investors away from funds that did not survive.
• Star rating versus expense ratio were even on predicting success ratio while star ratings did a better job in separating winners from losers.
• Overall, expense ratio beat star ratings in 58% of observations. Star ratings are less effective during market swings.
Actively managed funds that use market timing and security selection techniques in an attempt to outperform a passive index are more expensive than passively managed funds that attempt to capture the performance of passive indexes or asset classes after much smaller fees and expenses. Also, for two investors with the same return requirements, the one who pays higher fees and expenses must also incur more risk to obtain the same net result.
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