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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.

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.