Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors in search of mutual funds should put one criterion ahead of the rest: low expenses. Joining me to share some thoughts on low-cost active mutual funds is Russ Kinnel. He's director of manager research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Happy to be here.
Benz: Russ, you have done a lot of number crunching over the years on the factors that tend to predict good or bad performance for mutual funds going forward. One that your research keeps coming back to is the virtue of selecting low-cost investments. Can you summarize the state of your research on that topic?
Kinnel: Low costs are just the most dependable way to invest in funds. They work in any category, any time period we measure. Usually, we will measure the cheapest quintile on up to the most expensive; and virtually every time in any category or at any time period, the cheapest quintile beats the next cheapest and on up to the most expensive quintile, where you have poor performance, you have a greater likelihood that the fund will be eliminated. So low costs are just really dependable across the board.
Benz: Some investors assume that the only thing to focus on when looking for low-cost investments is just to look for index funds or ETFs, and those typically will be the cheapest of the cheap. But your research has found that if you look for low-cost active funds, you actually have a somewhat decent shot at beating a given market benchmark over time. How, if I'm looking at a universe of active funds, how high could I go and still have a chance at outperforming an index?
Kinnel: When I think of quintiles, I think in terms of you don't want to go past that middle or average quintile because then the odds are really starting to go against you unless you at least think that asset growth will lead fees to become much cheaper. Generally, you don't want to do that. If you want a rule of thumb, I would say something like 1% for equity funds.
Benz: Don't pay any more than that.
Kinnel: Yeah. And then 70 basis points for fixed income. Those are at least in the ballpark of what you want to look for.
Benz: And ideally even less, if you can get it.
Kinnel: That's right. By all means, why not start by screening on the lowest cost funds in a category and work your way down the list.
Benz: You brought a short list of active funds that have relatively low expense ratios. Let's start with a couple of bond funds. People know the big behemoths among bond funds, but this one is a little less well-known. It's Baird Aggregate Bond. Let's talk about that fund.
Kinnel: That's right. It's a fairly plain-vanilla fund. It charges only 30 basis points, so it can be plain vanilla. A lot of intermediate bond funds, at least the best known, have a lot of funky stuff: derivatives, exotic mortgages, currency bets. But this fund is very much high quality U.S. government mortgages, that kind of stuff--just what you'd expect. It does have a $25,000 minimum, which is how you get to such a low expense ratio, but I think it's a really nice trade-off for a very dependable fund.
Benz: Another low cost fund that you like is a municipal bond fund from Fidelity. I know Morningstar's analysts have historically liked Fidelity's muni team quite a bit. Let's talk about one of the funds that you like in Fidelity's muni lineup.
Kinnel: Fidelity Tax Free Bond is a Gold-rated fund, 25 basis point expense ratio, so super cheap. There aren't a lot of index funds to begin with in muni land, so it makes particular sense. This fund does have $25,000 minimum, too. Again, you're getting lower fees in exchange for a little higher minimum. But this is a fund, typical of Fidelity's offerings, that they really focus on issue selection. They've got very good researchers, both in terms of the quantitative programming side and the more fundamental side. It just makes for a very dependable fund. We really like this fund.
Benz: A lot of investors think of Vanguard as being the place for index funds or ETFs, but the firm actually has some very low-cost active funds as well. One that I know our readers really love is Vanguard Wellesley Income. Let's talk about that one and why you think it's a worthy active product.
Kinnel: That's right. Some of the best active funds are at Vanguard, because they're good at picking advisors and they have incredibly low costs. Vanguard Wellesley Income only costs 22 basis points for the investor share class, even cheaper for Admiral. It's run by Wellington Asset Management, very seasoned managers and analysts behind this fund. It's about a two thirds fixed income, one third equity, so pretty cautious fund. As the name implies, it delivers income. Nice boring fund, the kind that you can own through bear markets and bull markets.
Benz: Right. I know it's a favorite retirement holding for a lot of our readers. Let's talk about Dodge & Cox Global. Dodge & Cox is a firm that has historically had very low costs across the board.
Kinnel: That's right. Dodge and Cox doesn't wait for a fund to get a lot of assets. It starts its funds off at low cost. This fund charges 63 basis points. You've got a mix of their foreign and domestic equity picks. It's not quite the same as if you glued together there dedicated foreign and domestic fund, but it's really close. They are just good fundamental value investors with a long-term outlook.
Benz: Then rounding out the list is a T. Rowe Price small-cap fund. It's a little pricier than the rest, but this is maybe an area, the small cap space, where investors can perhaps justify paying a touch more than they might pay for that big, broadly diversified large-cap fund.
Kinnel: That's right, because I think small-cap funds benefit from smaller asset bases because it's hard to run them with big asset bases so you do often have to accept a little higher fee. T. Rowe Price QM US Small Cap Growth -- boy, that's a long one -- is 81 basis points. It's a little more, but it's still pretty cheap. It's a nice quantitative fund, diffuse portfolio. We rate it Silver. It's just an outstanding fund. It's hard to warm up to quantitative funds, but this one's just really done good job, and we have confidence in T. Rowe.
Benz: OK, Russ. Thank you so much for being here to share your thoughts on some low-cost actively managed funds.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.