Research keeps piling up to show that one of the best predictors for the success of a mutual fund is if it has low fees.
Whether the fund specializes in stocks, bonds or other investments, having low costs tends to lead to higher future returns.
The latest evidence comes from Russ Kinnel, director of manager research at Morningstar. He recently looked at returns for several categories of funds through 2015, from foreign-stock to municipal-bond offerings. He ranked funds in each category into five groups, based on their expenses.
For each type of fund, he found that the lowest-cost group had a higher rate of success than the second-cheapest, which had a higher rate of success than the third-cheapest, and so on.
To see how much your mutual fund charges in fees, check its expense ratio. The number shows what percentage of its assets goes each year to pay for manager salaries and other costs.
Many stock funds have an expense ratio of 1 percent, but most of the dollars invested are in funds that charge significantly less than that. Kinnel recently talked about the importance of keeping that number as low as possible.
Q: So, when I’m considering a mutual fund, the very first thing I should look at is its expense ratio, right?
A: I’m always careful to point out that it’s not all you need, but it’s a great place to start. It’s such a strong predictor of future success. Our data show that it works in all kinds of funds and in all kinds of markets.
And the longer you hold an investment, the more important it becomes. The compounding effect of getting into lower costs is huge.
Q: What about people who are comfortable being in a higher-cost fund because it’s done well for them the last few years?
A: We’ve tested it, and you can take the top performers and pit them against cheapest funds, and in the next five years, the cheapest funds will crush the top performers from the previous year.
Q: It feels strange for something with a lower price tag to be better than the “premium-priced” one.
A: When you’re looking at a fund’s expense ratio, you’re not looking at the dollars that the manager is paid. You’re looking at the percent (of the fund’s assets). Because of economies of scale, it’s often the case that the manager of the lower-cost fund is actually getting paid much more, because they’re running an $8 billion fund for 0.70 percent versus a $500 million fund charging 1.0 percent. The manager of the bigger fund is getting paid more.
Predicting fund success
One of the best predictors for the success of a mutual fund is if it has low fees. Whether the fund specializes in stocks, bonds or other investments, having low costs tends to lead to higher future returns.
Fund costs reduce your return. The longer you hold an investment, the more important low costs become, as lower costs benefit from a compounding effect over time.
In a performance test, Morningstar took the top fund performers in a given year, and pit them against cheapest funds. In the next five years, the cheapest funds crushed the top performers.