Do Expense Ratios Matter?

Russell Kinnel, Morningstar’s director of mutual fund research, wrote an article on August 9, 2010, titled “How Expense Ratios and Star Ratings Predict Success.” It is a must read and can be found online at Morningstar by clicking on this link.

Morningstar examined five broad categories of mutual funds—domestic equity, international equity, balanced, taxable bond, and municipal bond—over multiple periods beginning in 2005, 2006, 2007 and 2008 and ending in March 2010. The funds were sorted into quintiles based on expenses and the performance of the cheapest funds was compared to that of the most expensive.

We have always preached that investors should focus on the things they can control—expense ratios, turnover (i.e., tax efficiency), diversification, and asset allocation. Therefore, it did not surprise me that Morningstar’s research showed that cheap funds outperformed their expensive cousins in every time period tested. Kinnel observed “if there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision.”

Among both domestic and international equity funds, total returns in every time period were higher for the cheapest funds compared to the 5-star funds. Kinnel concluded by saying that "investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.”

All I can say is Amen!

In Fund Selection, Is It Wise to Reach for the Stars?

How often have you seen headlines on personal finance magazines touting Five Star Mutual Funds? You may figure that list generated by Morningstar constitutes great shopping ground. In fact, many professional financial advisors begin their analysis by evaluating those five-star funds.

It is human nature to be comforted by the idea that the investments you are buying are highly rated. The problem is that when we buy a “Five-Star” fund, we blindly extrapolate that the star rating translates into superior future performance. In fact, nothing could be further from truth. The Burns Advisory Group’s recent research paper, Star Gazing: Five Star Funds Revisited, went back to 1999 to study the subsequent 10-year performance of Morningstar’s five-star funds. The results were enlightening.

Burns found that of the 248 funds rated Five-Star by Morningstar on December 31, 1999, only four were still receiving that rating a decade later. Of the original sample, 87 had ceased to exist. And of those still existing, all had been downgraded to an average of just under three stars. And if this was not bad enough, the average performance for the five-star funds over this 10-year period was worse than the average for all funds in all categories except international stocks.

So what should you consider in making an investment decision? Clearly, a Five Star rating is nothing more than a starting point. You need a more broad-based evaluation, focusing on factors within your control. You might ask:

• Are the risks being taken related to return?
• Are those risks targeted in a reliable, consistent way?
• How diversified is the fund?
• What are the costs of the fund, i.e., expense ratio and turnover?
• Does it make promises it can't keep?
• What is more important - individual judgment or clear processes?
• Are the underlying strategies driven by forecasts?
• Does the fund take account of costs and taxes in its decisions?
• Does the fund manager communicate in a clear and consistent way?

While many of these attributes can lead to good outcomes, they cannot guarantee positive returns every year. However, the above characteristics can give you comfort that your money is being invested in a consistent, transparent way that ensures that when the targeted premiums kick in, you are positioned to receive them.

The bottom line is that we believe you should construct portfolios not around short-lived Five Star ratings, but based on the time-tested, enduring principles of asset allocation, broad diversification, passive management, and low costs.

Reaching for the stars today could mean you find yourself clutching at straws in the future.