Cheapest Funds Give Biggest Bang for the Buck

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar has long emphasized the importance of costs when selecting investments. Joining me to share some research that amplifies that finding is Russ Kinnel. He's director of manager research with Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: We've been talking about your latest research on expenses and the role that they play in future fund performance. You think it's a key predictor that investors should have on their radars. One thing we've talked about in the past is this issue of what you call success ratios. Let's start out by talking about what that is.

Kinnel: That's right. The success ratio tells you what are the chances that a fund survives and outperforms. Because it's a way of factoring in the fact that funds can get killed off and in fact when you look at on a fee level, cheap funds are much more likely to survive than expensive funds. So if we don't take that into account we're going to understate the impact of fees.

Benz: OK. So you brought some research that shows just how important fees can be in terms of determining a fund's future success rate. So what you did is that you showed--you separated funds by their expenses. You separated them into quintiles and then you looked at their subsequent odds of both surviving and outperforming.

Kinnel: That's right. I wanted to illustrate the fact that success ratio is obviously a two-part component, surviving and outperforming. So I thought it would be useful to drill down another level and say what happens on the outperformance basis and what happens on the survivorship extinction basis.

Benz: So one thing that I think is pretty stark and people may not think too much about this, is this survivorship thing. That if a fund is high cost, the odds of it making it really diminish, where you've got the funds in the highest cost quintiles, just surviving about 75% of the time.

Kinnel: That's right. High cost mistakes are often swept under the rug. So that when we look at results today it can understate that impact of high fees. And the reason is first off that high-fee funds are much less likely to produce good performance. If a fund company sees a fund that's got bad performance they are more likely to kill it off one because it makes them look bad. But two because they know that it's less likely that money is going to go into the fund they would have to really be patient and wait many years for performance to turnaround. Then on top of that high fees can be associated with a smaller asset base. So there is yet another reason those funds might--are more likely to be killed off.

Benz: I think this research also illustrates the virtue of looking for maybe some of the cheapest funds within a given category. Not just settling for average, because even at average your odds of outperforming and surviving are less than that very cheapest quintile.

Kinnel: That's right, this graph nicely illustrates the fact that things improve significantly as you get cheaper or you can say, the other way around, they worsen significantly with each quintile. As you mentioned comparing with average, the cheapest quintile only 20% of those funds underperform their peer group over a five-year period. Whereas just moving to the average quintile 40%. So double chance--double the chances of underperformance moving to the average quintile. Then if you look at on a survivorship basis only 7% of those cheapest quintile funds got killed off versus 18% for the average quintile. So again much more likely to have the fund liquidated on you, if you settle for average quintile.

Benz: So I shouldn't take too much comfort from the fact that my fund is average when it comes to expenses.

Kinnel: No, it's better than being pricey. But we see your odds just steadily improve the cheaper you get.

Benz: So let's take a look at another lens on this research, where you are looking at funds' outperformance that the cheapest group of funds within a given category relative to the most expensive group of funds. You actually show pretty starkly that the difference is dramatic here.

Kinnel: That's right. What we did in this case was looked at excess return versus the category average over a five-year period for the cheapest quintile versus the priciest. Again we're drilling down to another level than what we had looked at before and when you do that you see that again you just have significantly better returns. So this is a way of saying OK, I know my chances of outperformance are better with cheaper, but what are we talking about in basis points and we put some numbers on that as we look to the nine U.S.-style box categories.

Benz: So this goes category-by-category. One thing that jumped out at me when I looked at this is midvalue funds. Even though certainly the trend is here, it's not quite as stark as is the case with some of these other categories. What's your conjecture about why that is?

Kinnel: As you said all nine of these categories illustrate the point that cheaper does lot better than pricier. But this was the one where it gave you the least advantage, still an advantage of about 53 basis points. My guess is there were a couple of things going on. One there are not many index funds there, so the cheapest midvalue funds are probably don't have as big an advantage as in some other categories. And I think the other thing going on is there was a corner of midvalue it was very treacherous, energy and basic materials, even though they've rallied so far this year, they have been very hard hit. So a fund that had an overweighting in that area, even with a fee advantage they may have still lagged. Because you had extreme performance of those two sectors. Whereas the rest of midvalue did much better. So those two sectors really had an outsize impact on performance in that five-year period. Of course the next five-year period that may well not happen.

Benz: So you mentioned index funds and Jack Bogle of course has his Cost Matters Hypothesis. I think this research really illustrates that. Does this suggest that investors should just go for index funds and call it a day?

Kinnel: You can, I get that question often around this and I say well, I think it's just as easy to screen on low cost funds as it is on index funds. And the two are not synonymous. The cheapest funds out there are index funds. But there are pricier index funds, there are low-cost active funds. So I think it's really what's right for you. I think when you find a good low-cost active fund that's say charging 50 basis points you may well still have a very good option there. So I don't think it's simply that. But certainly I think you often, it doesn’t hurt to say set the bar at: Here's an index fund, here's a good index fund. Let's see if I can find an active fund with a fee and strategy and people advantages to overcome that. If not I'm going to take the index fund and be happy with it.

Benz: So hold your active funds to very high standards which maybe is an index fund.

Kinnel: By all means.

Benz: One last question for you, Russ. This last data set looks at domestic equity funds. Can you quickly summarize your findings in other asset classes, bonds and international equity?

Kinnel: What's great is how dependable fees are, it doesn't matter what the asset class is. So we saw very strong predictive value in muni bonds, taxable bonds, international equity, allocation funds. So any way you slice it, fees are really important and it just--because it just simple math you have that advantage and it doesn’t require a rally or a sell-off to work, it just steadily works and we looked at five years today, if you went out 10 or 15 or 20, the impact would be even more dramatic.

Benz: Okay, Russ. Great research here. Thank you so much for being here to discuss it.

Kinnel: You are welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.