In investing there is only one variable that an investor can control, and that is cost. Cost is vital to your long-term investment success. Lower costs necessarily result in higher returns. There is no disputing this fact. As an example, take two funds with the same gross return, Fund A and Fund B. Fund A has a 1% expense ratio and Fund B has a 2% expense ratio. After fees are deducted, Fund A will return 1% more than Fund B. Anybody capable of basic arithmetic should be able to figure this out. Yet, millions haven’t. The mutual fund industry is jam-packed with high-expense-ratio-load funds and those with 12b-1 marketing fees.
Morningstar, the fund data company most famous for its fund star ratings system, released a study this week on the predictive ability of expense ratios. Morningstar compared compound annual returns for five different categories of funds over five different time periods ending in March of 2010. The fund company split each mutual fund category into quintiles based on expense ratio and compared the returns on those quintiles. As Morningstar puts it, “Expense ratios are strong predictors of performance. In every asset class over every time period the cheapest quintile produced higher returns than the most expensive quintile.” For the domestic equity category, the lowest-cost funds on average performed 1.38% better per year.
The first item I look at when I’m evaluating a fund is cost. If a fund has a load or a 12b-1 fee, I won’t even consider it, nor should you. I don’t care what the fund invests in or how good a track record it boasts. When I buy mutual funds for myself, my family, and my clients, I buy only no-load, no-12b-1-fee, low-expense-ratio funds, and I advise the same strategy for you. It’s a guaranteed winner.