A funny thing happened when Morningstar performed a study on whether expense ratios or Morningstar “star” ratings are better at predicting higher future mutual fund returns. Expense ratios won. Russel Kinnel, Morningstar’s director of mutual fund research and study author, wrote about the study results on Morningstar and these quotes sum it up:
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.
The study didn’t look very far back, but it probably couldn’t because Morningstar keeps trying to tweak its rating system into something that… um… works. So they looked at the star ratings and expense ratios from mutual funds from 2005 through 2008, and then tracked their progress through March 2010. Funds were categorized into five broad asset classes: domestic stocks, international stocks, balanced, taxable bonds and municipal bonds.
The Morningstar rating system didn’t do awful. But considering that expense ratios are one single number, and Morningstar has millions of dollars available to make their rating system work by crunching historical data and take into account whatever multiple factors they want, it must be pretty depressing for them.
Heck, one of those recent tweaks was specifically to factor in expenses as part of the rating system. In the end, Morningstar ratings are still primarily based on past performance. Another quote from the article:
Perhaps the most compelling argument for expenses is that they worked every time–because costs always are deducted from returns regardless of the market environment. The star rating, as a reflection of past risk-adjusted performance, is more time-period dependent.
Is it just me, or does “time-period dependent” sound a lot of like “it works sometimes, except when it doesn’t”?
Investing based solely on past performance is as someone said, “like driving down a winding road using only your rear-view mirror”. Using the same driving analogy, I feel that investing with very low costs is like racing with a constant breeze at your back. (Or more accurately, all your opponents are driving into a constant headwind.) Over time, this relentless advantage will lead to above-average returns.
Next time you see an mutual fund ad touting their or ratings, just ignore it.