Morningstar has just released a study of the impact of mutual fund expenses on fund performance. It turns out that lower-expense funds outperform higher-expense funds–and expenses are a better “predictor” of future returns than Morningstar’s own star rating. In fact, Morningstar’s Director of Mutual Fund Research, Russel Kinnel, reports in an August 9 article on Morningstar.com, “How Expense Ratios and Star Ratings Predict Success,” that “In every single time period and data point tested, low-cost funds beat high-cost funds.”
It isn’t that the star ratings are not useful–but that the expense ratios worked every time. Kinnel explains further in the article that, “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 the study, Morningstar took funds in the highest and lowest quintiles of expenses, categorized them and compared total returns; “success ratio”–the percentage of funds that “survived and outperformed” rather than got merged or closed; and star ratings.
The thinking that “past performance has zero predictive power–went too far,” says John Rekenthaler, vice president for research at Morningstar. As part of the smack down between passive and actively managed investing, fees have become important, but “there is still value to” manager skill, as well. He cites a Department of Labor (DOL) proposal to “use computer models,” to direct investment in 401(k) plans, he told WealthManagerWeb.com, that “only apply investment style and cost, they don’t consider past performance.” That model misses whatever predictive power manager skill would have, he says, and would seem to favor a low-cost index type of fund–which of course gets investors beta, but no alpha.