Of Mutual Interest: Cheapskates, you're doing it right. At least in investing.
Research keeps piling up to show that one of the best predictors for the success of a mutual fund is if it has low fees. Whether the fund specializes in stocks, bonds or other investments, having low costs tends to lead to higher future returns.
The latest piece of support comes from Russ Kinnel, director of manager research at Morningstar. He recently looked at returns for several categories of funds through 2015, from foreign-stock to municipal-bond offerings. He ranked funds in each category into five groups, based on their expenses. For each type of fund, he found that the lowest-cost group had a higher rate of success than the second-cheapest, which had a higher rate of success than the third-cheapest and so on.
To see how much your mutual fund charges in fees, check its expense ratio. The number shows what percentage of its assets goes each year to pay for manager salaries and other costs. Many stock funds have an expense ratio of 1 percent, but most of the dollars invested are in funds that charge significantly less than that. Kinnel recently talked about the importance of keeping that number as low as possible. Answers have been edited for length and clarity.
Q: So, when I'm considering a mutual fund, the very first thing I should look at is its expense ratio, right?
A: I'm always careful to point out that it's not all you need, but it's a great place to start. It's such a strong predictor of future success. Our data show that it works in all kinds of funds and in all kinds of markets.
And the longer you hold an investment, the more important it becomes. The compounding effect of getting into lower costs is huge. In a single year, that 0.30 percentage point difference between the expenses of Fund A and Fund B is obviously not going to be a huge deal for your returns. But the way compounding works and the way that investing is a very long-term game, it adds up tremendously.
Q: What about people who are comfortable being in a higher-cost fund because it's done well for them the last few years?
A: I could say they overcame the fee in the past, so who cares? But the reason you should care is that fees are far more persistent than outperformance. Performance, especially in the short term, is a combination of luck and skill and fees and other things.
We've tested it, and you can take the top performers and pit them against cheapest funds, and in the next five years, the cheapest funds will crush the top performers from the previous year. We've gone so far as to say that if you put cheap funds with bad performance versus great funds with high costs, the cheap bad performers will win.
Q: It feels strange for something with a lower price tag to be better than the "premium-priced" one.
A: Often, we're inclined to think that if you pay more for something, you get something better. If I pay more for a car, computer or bottle of wine, I'm generally going to get something better. Not always, but generally.
There are a couple catches with that. One is that when you're looking at a fund's expense ratio, you're not looking at the dollars that the manager is paid. You're looking at the percent (of the fund's assets). Because of economies of scale, it's often the case that the manager of the lower-cost fund is actually getting paid much more, because they're running an $8 billion fund for 0.70 percent versus a $500 million fund charging 1.0 percent. The manager of the bigger fund is getting paid more. So it's kind of comparable to a Ford or Toyota versus if someone made a car for you by hand. It would cost 10 times more, but would probably be worse.
Also, fees are very persistent. All around, having low fees improves your margin for error. You don't know what the market's going to give you. If you know the next 10 years will be the greatest bull market ever, then great, you could probably buy a higher-cost fund. But it's probably more likely that the next 10 years will have subpar returns, and you're forking over an even bigger chunk of your return.
Q: Is a takeaway from this that we should just invest in index funds? They're often the cheapest funds.
A: That can be a takeaway. But not all index funds are cheap. If you look at ETFs, there's a lot of high-cost garbage out there. There are crazy ETFs for crazy niches. I'd turn it the other way and say: Stay with a low-cost provider, such as Vanguard, American Funds, Fidelity, T. Rowe Price, iShares.