Why fund costs matter so much

How costs predict success

Now that we've added the missing piece of attrition back in, we can see just how powerful expense ratios are as a predictor of performance. I again separated funds within each category into quintiles based on their costs, then checked on what percentage within each group managed to beat the category average. The category average overstates returns a bit because it reflects only funds still in existence today.

That's why even the best-performing quintile in our survivorship-free database saw slightly fewer than half its funds beat the official category average.

The results show just what a bad bet high-cost funds are. Funds in the cheapest quintile were more than twice as likely to succeed -- that is, beat the average for their categories -- than those in the most expensive quintile.

Success declines rapidly as you move up in price: Of domestic-stock funds, 47% in the cheapest quintile succeeded over a 10-year period, 33% of the next-cheapest quintile succeeded, 30% of the middle quintile succeeded, 27% of the second priciest quintile succeeded, and just 19% of the most expensive quintile beat the category average.

The pattern was similar in other asset classes. In foreign stocks, funds in the cheapest quintile were twice as likely to succeed as those in the priciest (40% to 18%). For bond funds they were five or six times as likely to succeed (48% to 7% in taxable bonds and 49% and 9% in munis).

Your chances against a cheap index fund

Those statistics are pretty compelling, but I also decided to look at how a fund's costs affect its chance of success versus a more formidable benchmark: the cheapest index fund in a category.

In particular, I looked at what percentage of funds within each cost quintile survived and beat the cheapest index fund in the category. It's a harder test than the previous one, of course, because the cheapest index fund in a category is usually the cheapest of any kind and index funds usually incur lower trading costs as well.

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Once more we see that low-cost funds fared much better. The cheapest quintile of equity funds was nearly twice as likely to beat the cheap index fund as the highest-cost quintile. The cheapest quintile of bond funds was six times more likely to beat the index fund than the high-cost quintile.

The cheapest quintile of domestic-stock funds survived and beat the cheapest index fund 29% of the time compared with just 17% for the most expensive quintile.

For international-stock funds, we see a similar picture: 32% of foreign funds in the cheapest quintile survived and beat the cheapest index fund while just 18% of the most expensive funds were successful.

For taxable-bond funds, 19% of the cheapest quintile were successful over 10 years and a mere 3% of expensive bond funds succeeded. There are no municipal-bond index funds to provide a benchmark test for tax-free funds.

Does this mean that all index funds are superior to all actively managed funds? No. There are high-cost index funds, too. If we asked how the average index fund fared against the lowest-cost actively managed fund, you'd likely see that most index funds lag the cheapest actively managed fund.

I'd be wary of drawing too broad a conclusion, such as that indexing is always better than active management, because the above compared the cheapest index fund against all active funds. Of course you can improve your odds by focusing on low-cost funds, whether choosing actively managed funds or index funds. Both types have higher-cost funds with low chances of success.

Low-cost funds double your chances of success

Factoring in survivorship to the expense equation shows just how powerful expenses are as a predictor.

Sure, there will always be exceptions. Winning lottery tickets are great investments; the catch is that you have no way of knowing if yours will be a winner, and they are bad investments for 99.9% of people.

From a fund company's perspective, high-cost funds are like free lottery tickets because it has persuaded investors to pay the bill. If the fund company is lucky, it'll produce big enough returns to attract large sums of money. If it isn't, it'll simply fold up the fund and hide its mistake under the rug. Of course, that doesn't make the fund's investors' losses any less real.

Rather than making a bad gamble, the savvy investor should look for low-cost funds with sound fundamentals. Simply doing that will double or triple your chances of success and greatly reduce your chances of dramatic underperformance.

In fact, our Analyst Picks (subscription required) apply those fundamental criteria, and they have succeeded about two thirds of the time. Using the FundInvestor 500 data tables, it's easy to see which funds offer the lowest costs in their categories.

You'll notice that the likes of Vanguard, American, Fidelity and Dodge & Cox are often among the cheapest. With the field narrowed, consider which funds, active or passive, have the best combination of low costs, good-quality management, sound strategies, diversification and stewardship you want. If you are patient, those funds will get you to your goals.

This article was researched and written by Russel Kinnel for Morningstar. An earlier version of this article appeared in the April 2007 issue of Morningstar FundInvestor.

Published March 3, 2008

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