Thursday, September 2, 2010

Who'd Have Thunk It: Expense Ratios Better Predictor of Future Performance Than Morningstar Ratings

I guess John Bogle was right after all, and "Bogle's Folly," the name used by the mutual fund industry to ridicule the first index fund, was a stroke of shear genius.  In an article comparing the star system to expense ratios, Morningstar concludes their analysis with:
Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.
For example, the cheapest quintile from 2005 in domestic equity returned an annualized 3.35% versus 2.02% for the most expensive quintile over the ensuing five years. The gap was similar in other categories such as taxable bond, where cheap funds returned 5.11% versus 3.82% for pricey funds. That same relationship held up dependably in the other time periods we measured. For 2008, the cheapest quintile of balanced funds lost 0.04% over the next two years, while the most expensive shed 1.13%.....
Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you'll be on the path to success.
Of course, they have to put in a plug for their star system, else why would anyone care about Morningstar ratings:
Stars can be helpful, too, particularly in identifying funds that might be merged out of existence. Even if a 1-star fund starts to perform better, there's always the danger that the fund company will decide that its track record is too poor and will fold the fund, forcing you to move your money elsewhere.
So they are really good at identifying the dogs, but not so great at identifying future superstars.  The star rating system is "a reflection of past risk-adjusted performance," and as we know past performance is no guarantee of future results.

Given this information, should I buy that micro-cap fund managed by a 23 year old "genius" with a 3% expense ratio that shot the lights out last year with a 90% return and now carries a 5-star rating, or a boring index fund that will chug along with long-term returns of 8 - 12%.  I think the choice is obvious.

Long-term S&P chart that mirrors typical investment lifetime for average investor-- a move from 17 to 1085


  1. The times now are kind of like the flat years from '65-'80. Could be a good time to get in a lower prices if you're considering the long haul.

  2. The evidence just keeps piling up. This is what the sage of Omaha was talking about:

    Most investors, both institutional and individual, will find the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.
    -Warren Buffett, Berkshire Hathaway chairman and legendary American investor, Berkshire Hathaway Inc. 1996 Shareholder Letter

  3. Grouch, great tip about the small expense ratios. It's silly to base your investment choices on the Morningstar's star ratings. I've had advisors use this alone for recommendations. I am drinking the Kool-aid on index funds. Low expense are the way to go.

    Slow and steady with low expense index funds.