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.