There’s an old adage that you get what you pay for – but a new analysis suggests that may not be the case for mutual fund returns.
The Morningstar analysis says that using expense ratios to choose funds helped in every asset class and in every quintile from 2010 to 2015. Russel Kinnel, Director of Manager Research, who authored the white paper, “Predictive Power of Fees,” notes that in U.S. equity funds, the cheapest quintile had a total-return success rate of 62%, compared with 48% for the second-cheapest quintile, 39% for the middle quintile, 30% for the second-priciest quintile, and 20% for the priciest quintile. “All told, cheapest-quintile funds were three times as likely to succeed as the priciest quintile,” he says.
The white paper says that that pattern was pretty similar in other asset classes. For example:
- international-equity funds had a 51% success ratio for the cheapest quintile, compared with 21% for priciest; and
- balanced funds had a 54% success rate for the cheapest quintile, compared with 24% for the priciest.
Limiting the fee test to just one share class per fund actually showed stronger predictive power. The success rate of returns in U.S. equity funds, for example, rose to 64% with just one share class versus 62% with all of them, and the priciest quintile falls to 15% versus 20% for all share classes. This was true in most asset classes except for international equity, where the success rates became more compressed, according to the analysis.
As for how the tests were conducted, Morningstar used historical data so that they were using the data that investors would have had access to at the time, though they acknowledge 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,” notes the report. “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.”
They looked at several 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. Then they calculated a “success” ratio for each measure. This ratio is Morningstar’s way of factoring in mutual funds that were merged away or liquidated over the ensuing period, while the other figures only include data on funds that survived the whole time period.
The report is available online at http://corporate1.morningstar.com/ResearchArticle.aspx?documentId=752589.
