DIFFERENCE BETWEEN GOOD MUTUAL FUNDS AND BAD: FEES

More damning evidence out this morning on the mutual fund industry.  It is widely known that the vast majority of mutual funds fail to add any value over a comparable standard index fund (some studies show that over 80% of all funds underperform their correlated index) and Morningstar is releasing a new study that supports such findings.  According to a new report fees are just about the only thing that differentiates a good fund from a bad fund (from Morningstar):

“How Expense Ratios Performed
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. To see the results, click here.

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.

For example, the cheapest quintile from 2005 in domestic equity returned an annualized 3.35% versus 2.02% for the most expensive quintile over the ensuing five years. The gap was similar in other categories such as taxable bond, where cheap funds returned 5.11% versus 3.82% for pricey funds. That same relationship held up dependably in the other time periods we measured. For 2008, the cheapest quintile of balanced funds lost 0.04% over the next two years, while the most expensive shed 1.13%.

The gap was also impressive as measured by the success ratio because high-cost funds are much more likely to have poor performance and be liquidated or merged away. For the 2005 group, we found that 48% of domestic-equity funds in the cheapest quintile survived and outperformed versus 24% in the priciest quintile. Put another way, funds in the cheapest quintile of domestic equity were twice as likely to succeed as those in the priciest quintile. It was a similar story in other categories, although in munis the advantage was greater than 6 to 1. The same basic relationship held up for the other years we looked at. Although I think of expense advantages as taking a long time to compound to your advantage, even the 2008 group saw low-cost funds with nearly a 2 to 1 success advantage.

Given that performance edge, you won’t be surprised to hear that low-cost funds also produced better risk- and load-adjusted performance as measured by the star rating. For example, the 2005 group enjoyed a subsequent 3.23 average star rating compared with 2.66 for the priciest quintile in domestic equity. The edge grew in taxable bonds to 3.34 versus 2.3. The edge held up for predicting three-year ratings for the 2006 and 2007 groups.”

The implications here are fairly obvious.  Most mutual fund managers aren’t adding any value over a standard index fund and the ones that are erase that value through their fee structure.  Luckily, for the small investor the options are becoming increasingly abundant across the index fund and ETF universe.  Fund managers who pigeonhole their strategy approaches and limit themselves to one segment of the market are destined to underperform over significant portions of the investment cycle.  Although there are certainly fund managers who add significant value this breed is becoming increasingly rare in the mutual fund space as most of the truly innovative investment thinkers now reside on bank trading desks or at hedge funds.

Source: Morningstar