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How Expense Ratios and Star Ratings Predict Success

We test the ability of expense ratios and star ratings to predict funds that will survive and beat their peers.

Russel Kinnel, 08/10/2010

We've run some fresh data on expense ratios and the Morningstar Rating for funds.

I'll share the details on who, what, and when, but first a few grabbers. How often did it pay to heed expense ratios? Every time. How often did it pay to heed the star rating? Most of the time, with a few exceptions. How often did the star rating beat expenses as a predictor? Slightly less than half the time, taking into account funds that expired during the time period.

In examining the expense ratios and star ratings, I settled on three key measures that, to me, are closest to investors' bottom lines and help cut through all of the clutter.

Success Ratio
While total returns are nice, they are not the whole story. Mutual fund companies kill off their funds at a rapid rate--thus, sweeping mistakes under the rug. However, your losses are just as real if your fund is liquidated. If there's a destruction bias for a data point, then you want to factor that in. The success ratio tells you what percentage of funds in a given group survived and outperformed their peers. After all, that's what success really is. Anything short is a failure; yet too often, investors and the press act as though total returns are the same thing as the success ratio. This is the strongest of the three measures because it is not affected by survivorship bias.

Total Returns
Everyone wants to know how any measure works at predicting total returns. Because equal proportions of each category are given 5 stars and 1 star, one can safely sum up returns across categories to see how the measure has done for an asset class as a whole.

Subsequent Star Ratings
The star rating is a measure of risk- and load-adjusted returns, so naturally I want to know whether the star rating is able to predict future risk- and load-adjusted returns. Investors have long handled lower-risk funds better than higher-risk funds because lower-risk funds don't trigger strong feelings of fear or greed. Thus, lower-risk funds with slightly lower official returns actually led to better results for investors than high-risk, high-return funds.

How We Ran the Data
We took a snapshot of star ratings and expense ratios from 2005 through 2008 and then tracked their progress through March 2010. We rolled up category level data into five broad asset classes: domestic equity, international equity, balanced, taxable bond, and municipal bond.

We then measured total returns as of the end of March 2010 for the mutual funds that survived the entire period. For the success ratio, we included funds that were merged or liquidated, as well as those that survived, in order to calculate the number that both survived and outperformed. For the star rating, we recorded the five-year star rating for the data set from 2005, as well as the three-year rating. For 2006 and 2007, we recorded the ensuing three-year rating--meaning we measured the figure in March 2009 for the class of 2006 and the rating in March 2010 for the class of 2007. For the class of 2008, we don't yet have a star rating.

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