Rules of the Fund Road: Watch the Fees, and Don’t Look Back; The expenses of a mutual fund often tell you something that its past performance can’t

Rules of the Fund Road: Watch the Fees, and Don’t Look Back

MAY 31, 2014

Strategies

By JEFF SOMMER

Investing would be easy if you could predict the future. Unfortunately, I can’t help you with that. But I do know a little about what works and what doesn’t work.

How an investment performed in the past doesn’t work: Past performance doesn’t guarantee future results. That thought should be familiar, since the Securities and Exchange Commission requires that it be published in all advertising dealing with mutual fund performance.

How much a fund charges in expenses does work. Within certain limits, fee levels provide an excellent guide to the future. Of course, fund fees in themselves don’t guarantee that you’ll do well with a particular investment; a bad bet doesn’t magically turn into a good one if the fees are low. But all things equal, you will be a lot better off if hefty fees aren’t eating up your returns. And low fees may tell you much more than that: When fees are low, the chances are much greater that an overall investment portfolio will outperform its peers.

These aren’t new ideas. But they are worth reconsidering right now, with five years of bull market returns behind us. Those performance numbers have radically improved the appearance of even the most ordinary of mutual funds and exchange-traded funds. But do those rosy numbers tell us much about the future, especially if the market changes direction?

Based on a new data analysis by Morningstar, the mutual fund tracking company, the old wisdom is likely to remain relevant today: Past performance isn’t likely to help you pick a mutual fund or E.T.F. for the future. But the level of a fund’s fees probably will.

Morningstar started with the investment universe that existed in June 2008. That was a turning point in the markets, though no one knew it with certainty at the time. The financial crisis would soon deepen, and a recession was already underway, though it wouldn’t be officially declared for months to come. The stock market was about to plunge horrifically, only to rebound in March 2009 and begin an epic bull market. None of that was clear at the time, either. At an important and difficult moment, it would have been very helpful to have a reliable guide to choosing investments.

Russel Kinnel, the director of fund research at Morningstar, examined fund fees as a guideline for mutual fund performance over the subsequent five years. And at my request, Annette Larson, a senior research analyst at Morningstar, ran a computer program aimed at analyzing whether fund performance over the previous three, five and 10 years would have been useful for picking funds.

The results were clear for fund fees, and Mr. Kinnel posted them on the Morningstar site. “I’ve found that low cost is the best single predictor of subsequent performance available,” he said in an interview. “It’s definitely not past performance. You should start with an allocation decision — say, you want to put a certain amount of money into the stock market — and then your next step probably ought to be to look for the cheapest funds that will give you that allocation. If you select your fund from that inexpensive group, you’ll probably outperform.”

In his study, Mr. Kinnel divided funds into five groups — quintiles — based on their expense ratios, a widely used measure of basic fund fees that can be easily found through Morningstar and many other services. The higher the expense ratio, the greater the fund’s cost for investors.

In each of Morningstar’s 112 fund categories — like small-cap growth stock, large-cap value stock, or intermediate-term bond — the funds in the cheapest quintile in June 2008 generally outperformed other funds in their peer groups over the next five years. And as the fund quintiles became more expensive, the percentage of funds that outperformed their peers dropped. The cheapest group of domestic equity funds, for example, outperformed 56 percent of their peers. The most expensive group in that category outperformed only 24 percent of their peers.

Those numbers refer to what Mr. Kinnel calls a fund’s “subsequent total return success rate” — the percentage of funds that existed in June 2008, survived as stand-alone entities for five more years and outperformed others in their category. The idea was to avoid “survivorship bias,” which afflicts studies that compare only those funds in existence at the end of an extended period. That would paint a rosier picture than investors actually experienced, because fund sponsors have an incentive to close or merge funds that perform poorly.

But remember that outstanding performance is no guarantee of future results. The Morningstar research performed for me certainly demonstrated that. It showed that in 2008, stock funds with the best past performance generally did not fare well in the subsequent five years.

For example, domestic stock funds in the top performance group in the previous three, five and 10 years generally did worse than most peers later. For bond funds, the results were different. Past performance was generally associated with better returns, perhaps because the bond market was more stable than the stock market in the ensuing years.

In short, investments with good past performance sometimes do well later and sometimes do very badly. Performance itself won’t tell you much about how an investment will fare in the future. Low cost won’t guarantee good results, either, but it almost always provides useful information and it improves your chances of success enormously.

John C. Bogle, the founder of Vanguard, has been saying that for decades. In an email conversation, he put it this way: “In the mutual fund industry, you not only don’t get what you pay for, fund investors as a group get precisely what they don’t pay for. Therefore, the less you pay, the more you get. And if you pay nothing, you get everything.”

So, as a starting point, try to pay very little. You’ll probably be better off later.