The giant of mutual fund ratings, Morningstar, has published a study making the case that low fees are the single best indicator of superior performance, not the company’s own five-star system. Investors focused on low-fee funds are likely to be better off over time.
The Wall Street Journal quotes Russell Kinnel, Morningstar’s director of fund research and the study’s author, as saying that fees “have proven to be the strongest predictor out there.” Kinnel’s study found, for example, that from 2005 to 2010, the cheapest domestic equity funds returned 3.35% a year, compared to 2.02% for their most expensive rivals. High-cost funds were also much more likely to have such poor performance that they end up liquidated or merged into other funds.
Kinnel himself writes:
If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.
The same cannot be said of highly ranked five-star funds. Morningstar’s research finds they do not always beat their lower-ranked competitors, and are especially unreliable in times of large market movements. In 2005, for example, five-star international funds that survived posted lower returns than similar one-star funds.
This is important information for mutual investors, who seem to generally put more weight on stars than they do on fees. In a 2001 study Diane Del Guercio of the University of Oregon and Paula A. Tkac of Federal Reserve Bank of Atlanta found Morningstar’s ratings have a “unique power to affect asset flow” into a mutual fund. An initial five-star rating, the duo found, lead to an average six-month abnormal inflow of $26 million in investor money, 53 percent above what would typically be expected.
In a May 6 column on shortcomings in Morningstar’s system, Jane Bryant Quinn came up with the following rules of thumb for investors:
- On average, one-star stock funds fall far enough behind the leaders that it pays to ignore them — even though they have good years.
- On average, five-star funds will lose their steam. Tomorrow’s big gainers will come from elsewhere in the pack. A three-star manager with five stars in his or her past might cycle back up, when those types of stocks get popular again.
- Each “star” group will have better and worse performers, and the stars can’t tell you which ones they’ll be.
- Low-cost funds in all categories get better star ratings than high-cost funds. That’s probably because the expensive funds take on more investment risk. They need higher returns to cover their costs and still be competitive. Their strategy might be successful but it’s also more likely to fail. That’s what “risk” is all about.
- Of all the so-called predictors of future performance, low cost is the only one that consistently works.