When choosing mutual funds for investors, advisors should look at expense ratios before anything else, including past performance. “The expense ratio is the most proven predictor of future fund returns,” according to a report just released by Morningstar.
Funds with the lower expense ratios not only tend to outperform other funds within the same asset category, but they also tend to stay in business longer, according to Morningstar. “High-cost funds are far more likely to get killed,” says Russel Kinnel, director of manager research at Morningstar.
In their latest study, researchers at Morningstar first separated funds within a particular category into different quintiles, based on their expense ratios. Then they looked at different performance metrics including total return; success ratio, which is the percent of surviving funds that outperformed their peers; and the frequency of that outperformance, known as their batting averages.
The result: Across different asset categories, funds with the lowest expense ratios performed best, over time periods of three, four and five years. The findings “worked for every category over every time period,” says Kinnel. That includes international equity funds and sector equity funds where active management is often thought to yield better results, even though those funds have comparatively higher costs.
The divergence in performance among funds in different expense quintiles was sizable. For example, U.S. equity funds with the lowest expense ratios had a 62% success rate over the five years ended Dec. 31, 2015 — three times greater than the success rates of funds with the highest expense ratio. The differential between the funds with the highest and lowest expense ratios within the taxable bond and municipal bond categories was even greater: near 3.5 times. This pattern repeated between other quintiles though the differentials were smaller, but in all cases, funds with lower expenses within a particular asset category outperformed the funds with higher expenses.
This trend holds even among emerging market funds, which can be very volatile. In the short run, volatility might matter more, but expenses matter more in the long term, says Kinnel. It doesn’t make sense for investors to choose higher expense funds in one category in the belief that they will outperform in, say, times of rising volatility and lower expense funds in other categories, explains Kinnel. “That’s like saying I don’t mind throwing over $5,000 here but I do mind throwing it over there. You’re equally poorer.”
Asked whether these study results are yet another argument in favor of passive index funds over actively managed funds, Kinnel says, “It’s about low cost, not active versus passive.” Passive funds may have the lowest costs, but not all passive index funds are less expensive than actively managed funds, says Kinnel.
What about those actively managed funds that have outperformed their peers consistently for a number of years? Kinnel says looking at past performance is like driving forward looking in the rearview mirror. It isn’t safe.
In addition, he said that Morningstar has found that high-cost funds that were top performers over the past five years are crushed by low-cost funds that underperformed during those same five years. “That tells you that fees are far better predictors of future return than past returns and that’s why fees should be your first screen, not returns,” says Kinnel.
After fees, he recommends that advisors and investors look at fund managers’ records, which would include past performance relative to other managers, as well as the extent to which portfolio managers own shares in their own funds and the stewardship grade of the fund company, which includes fees overall, corporate culture and quality of the fund’s board.
In separate news Morningstar this week launched four new fund categories and expanded its framework within its allocation category.
The new categories are Infrastructure equity funds, emerging markets bond funds denominated in local currency and long-short credit and option-writing categories, both under the alternatives umbrella.
Morningstar said the changes were made to keep categories relevant and insure they reflect the reality of investments being used. As a result, the star ratings of some funds could change.
The number of funds within the four new categories range from 20, for emerging markets bonds in local currency, to 35 for option-writing funds. Morningstar has 120 categories for 10,000 registered mutual funds, many more than the eight categories it first launched in 1988.
Morningstar also added two new breakpoints within its asset allocation fund category, based on equity allocations, for a total of five. It added a category for equity allocations between 15% and 30% of assets, where there was none before, and a category for equity allocations over 85% (previously the top category was 70% to 90% equities).
Morningstar also added another category for its target date funds — for 2060 and beyond — and it updated the previous top date, 2051+, to 2055, explaining that it’s been five years since it had added that category. Since that time 36 distinct 2060 target-date funds have been launched, according to Morningstar. In addition, all target date categories from 2015 on now have a single target date rather than a range, though 2060+ also includes funds with end dates beyond that particular year.
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