Unconventional Wisdom

Everything You Need To Know About Selecting Mutual Funds

Could everything that you really need to know about selecting mutual funds be contained on a napkin?  Probably not, but a recent Morningstar study suggests that examining a fund's expense ratio may tell you more than you can learn from reading Money Magazine or listening to the talking heads on CNBC.

Morningstar examined five categories of equity and fixed-income funds over multiple periods beginning in 2005, 2006, 2007 and 2008 and ending in March 2010. Funds were sorted into quintiles based on expenses and the performance of the cheapest funds was compared to that of the most expensive. They computed total return for funds surviving through March 2010 as well as a "success ratio" measuring the percentage of the initial group that went on to survive and outperform their peers.

Unsurprisingly, cheap funds outperformed their expensive cousins. Commenting on the results, Morningstar Director of Mutual Fund Research Russel Kinnel observed: "In every single time period and data point tested, low-cost funds beat high-cost funds.¹

Even more interesting, the study repeated the analysis using Morningstar's ratings and found that the expense ratio was a more reliable predictor of performance.  A lot of people might find that surprising, although we don't - see our previous post on this subject.  This is just another example of how actively managed funds (expensive) are unable to consistently outperform passively managed funds (inexpensive) and how performance of actively managed funds is usually inversely correlated with their expense ratio.  Because active management does not reliably create additional return, high expense ratios become insurmountable obstacles.

1. Russel Kinnel. "Fund Spy—How Fund Expense Ratios and Star Ratings Predict Success" Morningstar, August 9, 2010