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The Best Predictor of Future Fund Performance

By now most investors are painfully aware that, as the SEC-mandated disclaimer notes, past mutual fund performance is a poor indicator of future results. But that doesn't mean that fund investors are flying blind in their attempt to find superior future performance. As a recent Morningstar study found, there are a few characteristics that will help investors in that search.

In their study, Morningstar took a look at how well both their star ratings system and fund expenses did at predicting future success. (Success is defined by Morningstar as both surviving the period in question -- hardly a slam-dunk -- and outperforming the fund's peers.)

They found that their star ratings, which I wrote about a few months ago, did a very good job of identifying successful funds. Funds earning the highest rating of five stars outperformed the lowest-rated funds in 84 percent of the study's observations.

Not bad, but not as good as the impact of expenses. Morningstar also found that funds in the lowest-cost quintile outperformed their highest-cost peers 100 percent of the time. As Morningstar's Russ Kinnel wrote, "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."

Reinforcing that point, Morningstar's results showed that in both every period and every fund type they examined, the funds in the lowest-cost quintiles ended the period with a higher average star rating than the funds that were rated five stars at the period's beginning. The lesson? Performance, as represented by the star rating, comes and goes, often swiftly. But the benefits of low costs are much more enduring.

I admit that I was mildly surprised by the results, primarily because the Morningstar study focused on the most recent two- to five-year periods, and the low-cost advantage tends to become much more pronounced over longer periods of time.

Nevertheless, this is not a startling result. Way back in 1966, Nobel Laureate William Sharpe wrote that "the smaller a fund's expense ratio, the better the results obtained by its stockholders."

But the benefits of low expenses aren't limited to superior relative returns. Kinnel hinted at a secondary -- but equally important -- benefit when he wrote "Investors have long handled lower-risk funds better than higher-risk funds because lower-risk funds don't trigger strong feelings of fear or greed."

And low risk and low costs often go hand-in-hand.

To illustrate that point, I ran a similar analysis for the twenty years ended July 2010, separating all diversified domestic equity funds into deciles by expense ratio.

Again, the low-cost decile led the way, outpacing the high-cost decile by more than one percent annually. But the funds in the low-cost decile were also less risky, with a standard deviation that was 15 percent lower than the high-cost funds, and a Morningstar Risk (which is a measure of downside volatility) that was nearly 30 percent lower.

What explains this? Likely the fact that the managers of high-cost funds realize that they're operating at a distinct disadvantage relative to their low-cost kin. Thus, to overcome their cost burden, they're more likely to try to swing for the fences, taking on more risk in an effort to produce an outsized return.

Not only does this produce a great deal of volatility, it also makes it hard for investors to hold onto the fund for the long-term. Obviously, jumping into and out of volatile funds over time is a terribly unproductive way to build wealth, a point made clear by the record of CGM Focus, which I wrote about earlier this year.

The clear takeaway is simple: regardless of whether you prefer index funds, actively managed funds, or a mix of the two, the first criteria you should use to screen potential investments is expenses. Limiting your selections to the funds in the lowest-cost decile or quartile will vastly increase your odds for long-term success.

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