Choosing Funds: Low Costs or High Past Performance?

A reader writes in to ask,

“I’ve been doing lots of reading about investing, and things I’ve read suggest using index funds. I understand why I would want to use a fund with low costs, but I’m having a hard time getting on board with the idea of prioritizing low costs over high past performance. What’s the reasoning there?”

It’s certainly counterintuitive to refrain from choosing the funds with the highest return records. But research has shown that, within a given category of mutual funds (e.g., large-cap growth domestic stock funds):

1. Expense ratios are an excellent predictor of future performance, while
2. Past performance is not particularly useful as a predictor (with the noteworthy exception being that very poorly-performing funds typically continue to perform very poorly).

For example, in 1997, Mark Carhart performed a study of 1,892 mutual funds. Among his conclusions were that:

“Expense ratios, transaction costs, and load fees all have a direct, negative impact on performance.”

“The only significant persistence [in fund performance] not explained [by expenses, the three-factor model, and momentum] is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers.”

In other words, past performance can be useful for reliably identifying decidedly unskilled fund managers, but not for reliably identifying skilled fund managers. In contrast, fund expenses are a reliable way to select better-performing funds.

More recently, in 2010, Morningstar’s Russel Kinnel did a study to test how useful expense ratios and star ratings (which are based entirely on past performance) are as predictors of future performance. Kinnel summarized his findings:

“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.”

“Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.”

“Stars can be helpful, too, particularly in identifying funds that might be merged out of existence.”

In other words, we see once again that expense ratios are quite useful for predicting mutual fund success and that the primary usefulness of past performance is that it’s useful for showing which funds to be sure to avoid.

In addition to their “indices versus active” scorecards, Standard and Poors also puts out “persistence scorecards” from time to time. In the most recent one (from November 2011), they found that:

“12.23% of large-cap funds with a top-quartile ranking over the five years ending September 2006 maintained a top-quartile ranking over the next five years. Only 3.08% of mid-cap funds and 20.22% of small-cap funds maintained a top-quartile performance over the same period. Random expectations would suggest a repeat rate of 25%.”

In other words, picking funds based on superior past performance proved to be less successful than picking randomly.

They also found that:

“While top-quartile and top-half repeat rates have been at or below the levels one expects based on chance, there is consistency in the death rate of bottom-quartile funds. Across all market cap categories, fourth-quartile funds have a much higher rate of being merged and liquidated.”

Once again, past performance does prove useful for one thing: predicting the worst choices.

The above are just a small portion of studies that have reached a similar conclusion: If you want to maximize your chance of picking an above-average fund, your best bet is to pick one with below-average costs.