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Fund Fees Predict Future Success or Failure

Fund fees have remarkable predictive power, and investors can put them to their advantage.

Russel Kinnel, 05/05/2016

If you've been following Morningstar's research for long, you know how important we think expense ratios are to the fund selection equation. The expense ratio is the most proven predictor of future fund returns. We find that it is a dependable predictor when we run the data. That's also what academics, fund companies, and, of course, Jack Bogle, find when they run the data.

But it's been a couple of years since I provided the proof statement, so we have updated the data to show just how strong and dependable fees are as a predictor of future success. That's not to say investors should use them in isolation. There are many other things to consider, but investors should make expense ratios their first or second screen.

You can see all the data in our white paper.

How We Ran the Test
To begin any test of predictive power, we use historical data so that we are using the data that investors would have had access to at the time. That includes funds that no longer exist. In fact, that's a key part of the story because higher-cost funds are much more likely to fail and be merged away. If you do not factor them in, you will see better performance from higher-cost funds than was the reality, as those that survived naturally are more likely to have produced better performance while so many failures have been culled.

We looked at a few different measures to test how expense ratios worked: total return over the ensuing period, load-adjusted returns, standard deviation, investor returns, and subsequent Morningstar Rating. In addition, we calculated a success ratio for all the above measures. The success ratio is our way of factoring in mutual funds that were merged away or liquidated over the ensuing time period. The other figures only include data on funds that survived the whole time period. But the success ratio asks, "What percentage of funds survived and outperformed their category group?" Only funds that did both count toward the success ratio, as it is hard to argue that funds that no longer exist or underperformed were successful. For our tests, we began by grouping funds into quintiles within their peer group and then rolled that up into an asset class. That means we ordered each Morningstar Category, such as large growth, high-yield muni, and so on, into quintiles. Then we grouped all the cheapest-quintile funds in an asset class, then the second-cheapest-quintile funds, and so on.

We also ran all of the above tests against a universe in which only one share class per fund was included. Some readers of past studies wondered whether fees were as strong for selecting between funds rather than among share classes of the same fund. So, to eliminate comparisons of multiple share classes of the same fund, we limited this test to the oldest share class of a fund. 

We looked at the five years ended December 2015, the four years ended 2015, and so on. 

The Answer: Costs Really Are Good Predictors of Success
We've done this over many years and many fund types, and expense ratios consistently show predictive power.

Russel Kinnel is Morningstar's director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains. (Click here for a free issue). Mr. Kinnel would like to hear from readers, but no financial-planning questions, please. Follow Russel on Twitter: @russkinnel.

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