Expenses Matter When Picking Mutual Funds

Sept. 14, 2010— -- When it comes to picking investments, there are few things you can be absolutely certain about. But here's one thing you can count on: Mutual fund expenses matter.

Your chances of selecting a top-performing mutual fund are much greater if you focus on a fund's expense ratio. The more money a fund charges shareholders, the greater the chances the fund is a dog.

This is not a new conclusion. Studies have long shown that lower-cost mutual funds tend to outperform higher-cost funds. But this finding gained strength thanks to a recent Morningstar study that concluded low expenses are a better predictor of success than even the research firm's own star-rating system.

"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," the Morningstar study states. "In every single time period and data point tested, low-cost funds beat high-cost funds."

The study released in early August covered a period from 2005 through March of this year, comparing fund expense ratios and Morningstar star ratings as predictors of success. The results were broken down into five broad fund categories: domestic stocks, international stocks, balanced funds, taxable bonds and municipal bonds.

Morningstar found that in every category over each time period, the cheapest quintile -- the bottom 20 percent of funds in terms of costs -- produced higher total returns than the most expensive 20 percent.

For example, the cheapest quintile of domestic stock funds in 2005 posted an average return of 3.35 percent in the ensuing five years, compared with 2.02 percent for the top 20 percent as ranked by expense ratio.

Expressed as percentage of total investment, the expense ratio represents the amount fund shareholders pay annually for a fund's operating expenses and management fees. In 2009, the average expense ratio -- weighted by fund asset size -- for a stock mutual fund stood at 0.86 percent.

On a $100,000 investment, 0.86 percent works out to $860 per year. That doesn't sound too bad, but more than two thirds of U.S. mutual funds listed in the Morningstar database charge in excess of 1 percent. And more than a third assess annual expenses exceeding 1.5 percent. That means individual investors must take care to avoid being gouged.

In my book, there's no reason to pay more than 0.50 percent annually for a solid mutual fund.