Expense ratios predict future mutual fund returns

PoplatkyMorningstar is well-known for its research and analysis of mutual funds. The company was established in 1982, is present in 20 countries of the world and offers detailed information on cca. 350 000 investment vehicles to investors and financial advisors. Investors know its rating system based on stars from one to five. Funds that will belong to the top group in the next period according to Morningstar will receive five stars. Funds with returns worse than their peers and with terrible management will end up with one star.

Russel Kinnel of Morningstar is responsible for this rating system and for the rating of funds itself. He and his colleagues conducted a study published by their company on the predicting ability of its rating system in comparison to expense ratios of the funds. Many studies have already proven the ability of the expense ratio to separate the wheat from the chaff when it comes to mutual funds.

The authors compared 5 asset classes (domestic equity funds, foreign equity funds, municipal bond funds etc.) over 4 different time periods: 2005-2010, 2006-2010, 2007-2010, 2008-2010. In every asset class and every time period they compared the returns of the 20% cheapest funds and the 20% most expensive funds with the returns of funds with 5 and 1 stars. They also analysed whether funds with lowest expenses achieved higher returns than funds with highest expenses. Kinnel et al. focused on whether funds with lowest expenses had higher returns than funds with five stars and vice versa. By this they would show whether the expense ratio or star rating system is a better predictor of returns.

The results showed that in every asset class and every time period the cheapest funds beat the most expensive funds. For example, domestic equity funds with lowest expenses returned 3.35% p.a. over 2005-2010. The most expensive funds in this category and time period earned 2.02% p.a. The former funds achieved thus a better investment return by 1.33 percentage points p.a. When it comes to foreign equity mutual funds the difference was 1.21 percentage points in favor of the cheapest funds. However, there were periods when the star rating system failed – that is when the average return of five stars funds was lower the that of the one star funds. The expense ratio is thus a very strong predictor of future returns.

How Expenses and Stars Predict Success

Moreover, the authors analysed in the next step whether the 20% cheapest funds achieved better results than five stars funds and whether the 20% most expensive funds fared worse than one star funds. They used the so called total return succes ratio which is according to the authors a better measure of success than the mere return. I admit that I did not fully understand the interpretation of this ratio so I sticked to our old investment return. When I compared the mere average returns, the expense ratio was better than the rating system in 67.5% of the cases. For example in the domesting equity funds group (over the period 2005-2010) the cheapest funds achieved an average return of 3.35% p.a. whereas the funds with five stars returned only 2.79% p.a.

To choose funds with the lowest expenses is not obvious to everybody. One would thing that the more he pays for the management of the fund the better the manager and the higher his return will be. The reverse is true. The lower the expenses, the better off you are. The truth is that low-cost solutions in the world of mutual funds are more favourable to people than expensive fund managers. One could think that it is other measures or complicated systems that are able to predict future returns. That is not the case when it comes to investing. One look at expense ratios will do it. Complicated system like the one from Morningstar are not necessary. It is logical, too – the less money you pay for the management the more you will keep and the more money will work for you in your fund. Russel Kinnel, the author of the study concludes:”Investors should make expense ratios a primary test in fund selection. Start by focusing on funds in the cheapest or two cheapest quintiles, and you’ll be on the path to success.” I personally would focus on ultracheap passively managed index funds. They do not employ expensive portfolio managers, they do not claim having a crystal ball. They just try to buy as much companies and bonds as possible and to hold them as long as possible.

Source: Morningstar.


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