Why fund costs matter so much

To borrow from Woody Hayes, the late great football coach at Ohio State, when you buy a high-cost fund, three things can happen, and two of those are bad.

First, you can get good performance. Second, you can get underperformance. Third, the fund can perform poorly and then get merged away.

Yet, some people insist that costs aren't important -- because they remember only the first outcome. And, to be sure, there will always be some funds that manage to overcome high costs and outperform their peer group.

There's Federated Kaufmann (KAUFX), for example, which has produced outstanding 15-year returns even though it charges 1.95%. The much more common examples are funds like Westcott Nothing but Net and Phoenix Nifty Fifty, both of which came out with high costs, produced poor performance -- and then were put out of their misery.

However, funds that don't survive are an important piece of the puzzle when you study the predictive power of expense ratios. So, I set out to look at survivorship rates of low-cost and high-cost funds to get a true feel for your odds of success when picking funds of different expense ratios. Putting the pieces together that way led to a pretty stark picture.

Survivorship bias, or where high-cost funds go

Costs, after all, reflect not just fee structure but asset size. A small fund with high costs is more likely to be unprofitable for the fund company (and therefore a better candidate for the scrap heap) than a large fund with low costs. In addition, higher-cost funds sometimes take on greater risk than they otherwise would in order to compensate for their cost disadvantage. In turn, they put up ugly numbers that can lead to them being merged away or liquidated.

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Consider, for example, that all the technology funds in the cheapest quintile of their category in 1998 still existed five years later when the bear market in tech was ending and tech funds were rebounding sharply. However, 47% of funds in the priciest quintile were merged away or liquidated before the rebound.

That disparity is a little extreme, but the trend is borne out across the broad asset classes and within the individual categories.

I looked at rolling five-and 10-year periods from 1995 on to see whether high costs were a good predictor of whether a fund would be merged away or liquidated. Within each category, I separated funds into quintiles based on their costs, and I excluded categories where there were fewer than five funds per quintile.

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It turns out there's a high correlation between costs and survivorship, as high-cost funds had a striking attrition rate. For U.S. stock funds, the quintile with the lowest expense ratios had an attrition rate of 13% over five-year periods and 25% over 10-year periods.

However, the attrition rate for the most expensive quintile was double that: Over five-year periods, 29% of the high-cost funds had merged or liquidated, and nearly half (49%) had merged or liquidated over 10-year rolling periods.

The pattern was similar for international stocks and taxable-bond funds, though both groups had higher attrition rates across the board.

For international-stock funds, the cheapest quintile had an attrition rate of 19% for five-year periods and 33% for 10-year periods, while the attrition rates for the priciest quintile were 37% and 57%, respectively, for the five- and 10-year periods.

Taxable-bond funds in the cheapest quintile saw a five-year attrition rate of 21% and 35% for 10 years, while the priciest quintile had a five-year attrition rate of 37% and a 10-year attrition rate of 57%. The really striking part here is that not even half of those high-cost funds survived over a 10-year period.

A recipe for disaster

Put that all together and you have a recipe for failure. When a fund comes out of the gate with a few years of bad performance, the fund company, realizing that it will have an awfully hard time attracting assets, kills it off.

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Interestingly, muni funds broke the pattern, as attrition rates of low-cost and high-cost funds were pretty close. The five-year attrition rate for cheap muni funds was 29% and the 10-year rate was 40%, while the priciest quintile shed 25% in five years and 39% in 10 years.

I'm not sure why that is. It may be that the small firms launching trendy junk are less likely to venture into munis, where there's no chance of producing the sort of huge returns that quickly attract money. In addition, the gap in costs between pricey and cheap funds is smaller and therefore the higher-cost funds have less of a disadvantage than high-cost stock funds.

Continued: How costs predict success

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