From the November 2008 issue of Boomer Market Advisor • Subscribe!

Dispel the low-cost mutual fund mixup

Do low-cost mutual funds outperform their higher-cost brethren? This is the belief of many boomers: if the underlying costs for management, distribution, operations and administration are at the low end of the spectrum, it's automatically a good thing. The corollary is that any fund that costs more than the average is unlikely to succeed and should be ignored. Our study shows that the opposite is often true.

Using data from Morningstar, we ranked 34 categories of mutual funds on the basis of two very straightforward statistics (as of April 10):

  1. Their expense ratio (how much the average fund in a category costs).
  2. Their 10-year alpha (how much return the average fund manager in a category added through skill, regardless of what the market did).

We looked at the 69 mutual fund categories Morningstar uses to segment the more than nearly 25,000 funds traded in the United States. We eliminated specialty funds such as industry-specific equity funds, geographic segment funds, single-state muni funds, etc., which reduced the list to 34 categories. Our intent was to restrict the study to fund categories that were diversified. We also eliminated the broad-based and specialty funds that invest strictly outside the United States. It is a given that if the U.S. dollar gets pounded (pardon the pun) as it has during this period, that any exposure to international or emerging market stocks or bonds would produce better returns. International exposure is not required, but is allowed (such as world stock, world allocation and target-date funds).

In the case of expense ratio, the lowest cost fund category received a ranking of one. The most expensive fund category was given a ranking of 34 (under the assumption that lower cost is better).

In the case of 10-year alpha, the highest alpha-producing fund category received a ranking of one, and the lowest was given a ranking of 34. Higher alpha is better.

To add to the intrigue, we note that the 10-year return of the S&P 500 stock index was 3.7 percent over this period. In other words, the last ten years were a very good time to own funds run by skilled managers, instead of an S&P Index fund (which, by the way, is a low-cost investment).
The results of the study are as follows:

  1. Of the 34 mutual fund categories studied, the 10 that produced the highest 10-year alpha had an average expense ratio rank of 28. That is, the fund categories that showed the most skill were also among the most expensive.
  2. The top 10 alpha rankings were dominated by small and midcap fund categories. Translation: these managers in general were able to maneuver better investing in smaller companies over this period compared to their large-cap competitors, who could not distinguish themselves from investing in an index.
  3. World allocation funds ranked eight in alpha (and 29th in cost). This is likely due to a combination of manager skill in this area and the long slide in the U.S. dollar, which has lifted non-U.S. investments.
  4. The long-short category of mutual funds ranked seventh in alpha, despite being the highest-cost fund group by a wide margin. In other words, employing short positions alongside long positions in a mutual fund overcame the higher cost of doing so, and substantially out-skilled nearly 80 percent of the competition.

This is just the beginning of the work we will do in this area and related ones. For now, the conclusions are obvious to us: if you want low cost, buy low-cost funds. If you want skill, don't be afraid to pay for it.

As one industry colleague has said, investors have been "Bogle-ized" (referring to John Bogle, the mutual fund veteran who founded Vanguard Funds and has been a leading proponent of the "low-cost equals better results" theory). There is plenty to like about indexing and low-cost investing; just don't be blinded by its limitations.

Bottom line: do not simply assume that fund expense ratio overrules everything else in choosing mutual funds, especially when your hard-earned money is on the line. Don't be "penny-wise, pound foolish."

Robert Isbitts is chief investment officer and principal of Weston, Fla.-based Emerald Asset Advisors. He can be reached at (954)385-9624.

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