Fees, Trading Costs and Tax Impact on Fund Performance

Overall, for Large Cap U.S. stock funds, predictions made by our simple formula were more accurate than predictions by past performance 70% of the time. For International stock funds, our predictions beat predictions by past performance 77% of the time.

Impact of Expense Ratio and Turnover on Fund Longevity

Expense ratio and turnover are also negatively associated with fund longevity. The higher the expenses and turnover, the more likely the fund will shut down sooner. This is unsurprising, as high expenses and turnover increase the likelihood of poor performance, poor performance leads to decreased purchases of the fund, and an increased withdrawals from the fund, with corresponding lower profitably for the fund manager.

To illustrate the relationship between expense ratio and turnover and longevity, we looked at two subgroups of each fund category at the end of 2006 — those with the lowest expense ratio and turnover during the years 2000-2006, and those with the highest expense ratio and turnover during that period.

Nearly all fund categories in the low cost funds were meaningfully more likely to survive than the high cost funds of the same category. For example, among U.S. small/mid-cap stock funds available at the end of 2006, 88% of the low-cost funds were still operating at the end of 2016, while only 45% of the high-cost funds were still in business.

Tax Consequences

A fund’s total return may include capital appreciation, capital gains distributions, and dividend and interest distributions. For a fund held in a taxable (non-retirement) account, capital gains distributions, dividend distributions and some interest distributions are taxable in the year that the distributions are made.

The cumulative capital appreciation is taxed only when the fund shares are sold, and if held for more than one year, at the relatively low long-term capital gains rate. A tax-efficient equity fund would deliver most of its return in the form of capital appreciation, minimizing capital gains distributions, and with dividend distributions limited to the dividend yield of the average yield of the stocks in the fund category, and with no taxable interest distributions.

There is a wide range of tax efficiency in equity funds, with some funds regularly selling appreciated stocks and returning more capital gains distributions than other funds.

We discovered that funds generally maintain a consistent degree of tax efficiency over time, that is the most (least) tax-efficient funds in one period tended to remain the most (least) tax-efficient in the subsequent period.

Within equity funds, there is more variation in tax efficiency between growth and value funds as opposed to between different capitalization classes (large-cap vs. small-cap) — value stocks tend to pay higher dividends than growth stocks, while growth funds tend to realize more capital gains on appreciated holdings than do value funds.

Good advisors focus on protecting and growing client assets. Smart individual investors strive to make sound financial decisions on a journey toward financial independence. Both groups seek an edge to those means. When it comes to investing in funds, avoiding costs and fees and other expenses over the long haul is just plain smart. With these new benchmarks we offer prudent investors the ability to do just that.

Stefan Sharkansky is the creator of Personal Fund, a tool for financial advisors that uses proprietary cost analysis of mutual funds to more accurately compare costs, expenses and fees against similar funds. Sharkansky is also a principal with Useful Work Inc., which helps high-net-worth individuals better manage their tax-efficient passive equity portfolios.