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Looking for the Best Mutual Funds: Follow the Costs

One of the best determinants in looking for the better performing mutual funds in a specific category is its expense ratio. In a recent article in MorningstarAdvisor.com, Morningstar’s director of mutual fund research Russel Kinnel took a look to see the correlation between fund performance over time and its underlying expense ratio.

Kinnel separated mutual funds into quintiles based on underlying costs to see what percentage of funds from each cost quintile was able to beat the category average. Of domestic stock funds, 47% in the cheapest quintile succeeded in beating the category average over a ten year period, 33% in the next quintile, 30% in the following quintile, 27% in the next and just 19% in the costliest quintile. Or in other words, you are over twice more likely to beat the category average if you are in a low cost fund than in an expensive fund. The success disparity was also similar for other fund categories. For foreign stocks the probability of category out-performance between the low cost funds versus high cost funds was 40% to 18%, for taxable bond funds this was 48% and 7%; 49% and 9% in municipal bonds.

Kinnel then compared the cost quintiles against the cheapest index fund in each particular category. The results clearly favored the low costs funds succeeding as compared to the high cost funds. But what is revealing is how low the odds were for even a cheap fund to beat the most efficient comparable index fund. Of the cheapest quintile in each category, only 29% of domestic stocks, 32% of foreign stock and 19% of the taxable bond funds were able to beat the cheapest index fund.

This just goes to show that it is extremely hard to beat a cost effective fund over time, but it really is another example of why low priced index funds are hard to beat. Think about it. If you were playing five card poker and the dealer allowed you the option to receive an ace in every deal that you received, wouldn’t you take that ace each and every time? With the high probability of out-performing even the most cost effective actively managed funds, the odds of investing success are well in your favor and essentially your ace in the hole when it comes to investing.

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