Client-focused financial advisors recognize that a mutual fund’s past performance does not guarantee future results. Indeed, fund performance in one period is generally uncorrelated with performance in a subsequent period. But are there other criteria that can deliver insight on the funds that have the best chances of performing better than their peer funds?
Yes. The simple characteristics of expense ratio and turnover offer valuable investment insights. We analyzed and updated those benchmarks in a recent study examining roughly 46,000 mutual funds and ETFs of several asset classes for the years 2000 through 2016.
In all fund categories, funds with lower expense ratios predictably earned higher returns. In most fund categories, the funds with lower turnover earned higher returns. Funds with the highest expenses and turnover were more likely to go out of business sooner than funds with more modest expenses and turnover.
Moreover, past tax efficiency predicted future tax efficiency. The most tax-efficient funds in one period tend to be the most tax efficient in the subsequent period. The study also included a new estimation of uncompensated trading costs, which showed a statistically meaningful negative association between reported turnover (the closest available proxy for trading behavior) and returns for equity funds.
Consistent with the findings of many other researchers, we corroborated that the average pretax return of a mutual fund is equal to the return of its asset class less the fund’s expense ratio and its internal trading costs.
Critically, for stock funds, the trading costs may be estimated by a simple formula based on the fund’s reported turnover, the average reduction in annual return per 100% turnover is: U.S large and multi-cap funds: 0.41%; U.S. mid- and small-cap funds: 0.53%; international and global funds: 0.87%.
Predictive Ability of Past Turnover and Expense Ratio on Future Returns
Also illuminating was that projections of average portfolio performance based on expense ratio and turnover predict future performance better than do past returns.
In some, but not all of the fund categories, a handful of the top-performing higher-expense/higher-turnover funds bested all of the low-expense/low-turnover funds in their category. But for all fund categories, and at all, or nearly all quantiles, the lower cost funds outperformed the higher cost funds. And in particular, the higher cost funds had a much greater downside risk than the less expensive funds.
For example, among large-cap U.S stock funds the higher cost funds had an 11% chance of beating a closely comparable index fund by at least 1% annually, while the lower cost funds had a roughly 19% chance of beating a similar index fund by at least 1% annually.
On the other hand, the lower cost funds had a 13% chance of underperforming the comparison index fund by 1% or more annually; while the higher cost funds had a 54% chance of underperforming by 1% or more annually.