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Which Is a Better Performance Predictor: Star Ratings or Expense Ratios?

Last Updated Oct 8, 2010 9:12 AM EDT

The public has a high regard for Morningstar and its research. We know this as cash flows from investors are positively correlated with changes in star-ratings. And Morningstar certainly puts a great deal of effort into its ratings. However, I learned long ago that while we should value effort in many endeavors, in business and certainly investing, all that matters is results. Thus, the questions are whether Morningstar's efforts are productive, and whether it would better serve the public by spending its resources on other endeavors.

Russell Kinnel is Morningstar's director of mutual fund research. In August, he published the results of a study he did on whether star ratings or expenses were the better predictor of future performance. Unfortunately for believers in star ratings, the results showed that expense ratios are better predictors. In fact, wherever they looked -- domestic equity funds, international equity funds, balanced funds, and both taxable and municipal bond funds -- Morningstar found that expense ratios always mattered. Quoting Kinnel: "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. In every single time period and data point tested, low-cost funds beat high-cost funds. 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."

Consider these differences for the five-year period ending March 2010:
  • The cheapest quintile of domestic equity funds had an annualized return of 3.35 percent, while the priciest had a total return of 2.02 percent, for a difference of 1.33 percent.
  • The cheapest quintile of international equity funds had an annualized return of 6.46 percent, while the priciest had a total return of 5.25 percent, for a difference of 1.21 percent.
  • The cheapest quintile of balanced funds had an annualized return of 3.76 percent, while the priciest had a total return of 2.87 percent, for a difference of 0.89 percent.
  • The cheapest quintile of taxable bond funds had an annualized return of 5.11 percent, while the priciest had a total return of 3.82 percent, for a difference of 1.29 percent.
  • The cheapest quintile of municipal bond funds had an annualized return of 3.83 percent, while the priciest had a total return of 2.75 percent, for a difference of 1.08 percent.
This isn't the first time Kinnel has mentioned how important costs are. In his 2004 article, "Time to Clear Out the Dead Wood," he mentioned costs as a way of selecting a fund: "What's the best predictor of a fund's returns? Its costs. There will always be the odd funds with a high expense ratio that puts up good returns (usually for a short period of time), but nine times out of 10 high costs will ruin a fund. We tested funds with strong past performance and high costs against those with poor past performance and low costs. Sure enough, those with low costs outperformed in the following period."

As he noted in his book Bogle on Mutual Funds, John Bogle found the same thing when he studied the performance of bond funds. His conclusion: "Although past absolute returns of bond funds are a flawed predictor of future returns, there is a fairly easy way to predict future relative returns." Bogle found that "the superior funds could have been systemically identified based solely on their lower expense ratios."

While investors and the media focus on past performance, the mundane issue of costs is the best predictor of future returns. As a group, you'd be far better off if you simply followed the advice of Warren Buffett: "Most investors, both institutional and individual, will find that 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."
For more on this study, see the post from my MoneyWatch colleague Nathan Hale, "The Best Predictor of Future Fund Performance."
More on MoneyWatch:
Why Index Funds Only Receive Three Stars from Morningstar When You Wish Upon a Morningstar Does Waddell & Reed Back Up Its Claims? Has Vanguard Joined the Investment Porn Crowd? Stocks Are Dying, Again
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.