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.

Advantages of Low-Cost Funds No Surprise

To those of us who tout the advantages of low-cost funds, Morningstar's findings about the correlation between low expenses and superior fund performance are not surprising.

But what is surprising, and even admirable, is Morningstar's willingness to acknowledge that expenses are a better predictor of fund performance than its own star-rating system.

Morningstar made its name as an investment research firm by attaching one to five stars to the thousands of mutual funds it analyzes on a regular basis. A one-star rating is reserved for the very worst funds; a five-star rating is the gold standard coveted by fund firms. The ratings are based on risk-adjusted performance, meaning returns are assessed relative to the level of risk taken by a fund.

The higher the risk level, the higher returns needed to earn a five-star rating. On the other hand, a low-risk fund that posts higher returns than comparable funds will earn a higher rating.

The problem with Morningstar ratings is that they are based entirely on past performance. There is nothing that can guarantee such performance in the past three or five years can continue.

In its own study, Morningstar found that its star ratings proved to be a strong predictor of success "most of the time," compared with every time for expenses.

Looking at five-star mutual funds versus one-star funds, the stars guided investors to better decisions 84 percent of the time, the study found.

Domestic stock funds given a five-star rating in 2005 produced a 2.8 percent annual return through the following five years compared with 1.6 percent for the one-star funds. Similar results were found in the balanced and municipal bond fund categories.

The one exception occurred among international stocks. In that category, one-star funds enjoyed better returns than five-star international stocks funds. But that result includes only funds that continued to exist in 2010. As many lousy funds get shut down, this measure is biased toward better performing funds.

Always Check a Fund's Expense Ratio

When Morningstar included extinct funds in its review, it found that the star-rating system also helped in the international stocks category. Comparing the predictive value of expenses versus its own rating system, Morningstar found that expense ratios outdid the star ratings 58 percent of the time.

"Perhaps the most compelling argument for expenses is that they worked every time, because costs always are deducted from returns regardless of the market environment," Morningstar states.

Its star-rating system is more time-period dependent. "When the market swings dramatically, the star rating is going to be less effective."

What does this all mean for the average individual investor?

It means you should always check a fund's expense ratio when making an investment.

When picking funds in your company 401(k), lean toward the lower-cost funds. You want to be sure to include representatives of the major asset classes in your fund lineup, but when choosing between funds within those categories -- U.S. stocks, international stocks and bonds -- use expenses as major criteria.

And pay attention to the fund's Morningstar rating. Just be aware of what those stars mean and that they have their limits. Remember, they look backward, not forward.

As I said in the beginning, there are few guarantees available when it comes to investing. But there are ways to dramatically improve your chances of success.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is a Certified Financial Planner professional and founder of Four Ponds Financial Planning LLC (www.fourpondsfinancial.com) in Falmouth and Mansfield, Mass. Contact McPherson at david@fourpondsfinancial.com