Cost is boss when it comes to performance

I often comment on how difficult it is to predict which securities will rise above their peers to deliver higher returns.  Frustrating as it may be, there’s just no systematic way to consistently identify winners and losers in advance.  However there is one data element, widely ignored by analysts and commentators, that has some predictive value: expense ratio.

The expense ratio of mutual funds and ETFs is the portion of fund assets consumed by management, marketing and transaction costs.  Expenses vary widely, from a few basis points for some index ETFs, to two hundred basis points or more for some “exclusive” actively managed funds. Most of the fund industry hates talking about expenses as they drive profits. I love talking about them because they are a prime consideration when we choose ETFs.

Using expense ratios as tea leaves

In a study of expense ratio as a predictor of future performance Vanguard found that funds with the lowest costs were three times more likely to beat their index benchmarks than those with the highest costs.

The research looked at the performance of actively managed style funds relative to their relevant index benchmarks. Funds were sorted into four quartiles by expenses. The funds in the lowest cost quartile beat their benchmark in 49 percent of cases over 20 years (1990-2010).  Only 16 percent of the funds in the highest cost quartile beat the benchmark over the same period.

Outperformance of U.S. equity mutual funds by expense-ratio quartiles: 5, 10, 15, and 20 years ended December 31, 2010*  Source: Vanguard Group.

The results were the similar for shorter periods – low cost funds always outperformed their benchmarks more often than those in the second, third, and fourth cost quartiles.

This result may not be so surprising – costs directly reduce return to the investor. However, few market experts seem to want to hitch their wagon to a stat as mundane as expense ratio when predicting winners and losers.  It is much sexier to base predictions on earnings reports, past performance and political and economic news. Unfortunately those data points don’t have much predictive value.

Past performance tells us little about the future

Many fund managers try to lure new investors by publicizing better than average past performance. Conditioned by sports and other events where top performers tend to stay on top, we can be easily influenced by past performance of stocks and funds. But we shouldn’t be.

Vanguard found that actively managed funds in the top quartile of performance for 1, 3, 5 and 10 year periods were unlikely to stay there.  For instance, only 19 percent of top quartile performers from 1990 to 2000 stayed in the top quartile for the subsequent decade.**  Vanguard found similar results for the shorter periods as well – no statistically significant advantage over funds chosen at random (25 percent of which would fall into the top quartile).

Control what you can

This research supports one of the primary investment tenets at Osbon Capital – the measure that matters most is how much you keep after expenses and taxes.  Expenses play a big role, and you can control them.

See our article, “Fees: A portfolio’s silent killer.”

*Notes: Data reflect percentage of U.S. equity mutual funds that outperformed their style benchmark for periods ended December 31, 2010. Data include only funds that survived the respective 5-, 10-, 15-, or 20-year periods. “U.S. equity mutual funds” refers to all funds, including those focused on a particular style or market capitalization such as large growth or small value. Sector funds, specialty funds such as bear-market funds, and real estate funds were excluded from the list.  Sources: Vanguard calculations, using data from Morningstar, Inc., MSCI, and Standard & Poor’s. Style benchmarks represented by the following indexes: large blend—S&P 500 Index, 1/1/1990 through 11/30/2002, and MSCI US Prime Market 750 Index thereafter; large value—S&P 500 Value Index, 1/1/1990 through 11/30/2002, and MSCI US Prime Market 750 Index thereafter; large growth—S&P 500 Growth Index, 1/1/1990 through 11/30/2002, and MSCI US Prime Market Growth Index thereafter; mid blend—S&P MidCap 400 Index, 1/1/1990 through 11/30/2002, and MSCI US Mid Cap 450 Index thereafter; mid value—S&P MidCap 400 Value Index, 1/1/1990 through 11/30/2002, and MSCI US Mid Cap Value Index thereafter; mid growth—S&P MidCap 400 Growth Index, 1/1/1990 through 11/30/2002, and MSCI US Mid Cap Growth Index thereafter; small blend—S&P SmallCap 600 Index, 1/1/1990 through 11/30/2002, and MSCI US Small Cap 1750 Index thereafter; small value—S&P SmallCap 600 Value Index, 1/1/1990 through 11/30/2002, and MSCI US Small Cap Value Index thereafter; small growth—S&P SmallCap 600 Growth Index, 1/1/1990 through 11/30/2002, and MSCI US Small Cap Growth Index thereafter.

**Notes: Each fund was evaluated relative to its customized benchmark using the Fama-French-Carhart expanded market model (Fama and French, Journal of Financial Economics 33:3-56, 1993; Carhart, Journal of Finance 52:57-82, 1997).  Sources: Vanguard calculations, using data from Morningstar, Inc. Data exclude sector funds, real estate funds, and specialty funds such as bear-market funds.

This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

Nothing in this article is intended to be or should be construed as individualized investment advice. All content is of a general nature. Individual investors should consult their investment adviser, accountant, and/or attorney for specifically tailored advice.

Any references to third-party data or opinions are listed for informational purposes only and have not been verified for accuracy by the Adviser. Adviser does not endorse the statements, services or performance of any third-party vendor without specifically assessing the suitability of a third-party to a client’s or a prospective client’s needs and objectives.

Past performance is no guarantee of future results.

An investment cannot be made directly in a benchmark index.