In August of 2010 the renowned investment research company Morningstar released the results of a study they had conducted to determine the best way to predict future mutual fund returns.
Specifically, they compared two big factors:
- The mutual fund’s expense ratio, which is the ongoing cost of owning the fund.
- Morningstar’s own star rating system, which factors in variables like the fund’s past performance, its process, and its managers in addition to its cost.
Morningstar’s star rating system performed very well. Across all types of investments (stocks, bonds, etc.), the highest-rated mutual funds outperformed the lowest rated funds 84% percent of the time. And this is what you would expect given the number of variables factored into these ratings and the expertise of Morningstar’s staff.
But even with all of that expertise and precision, they still couldn’t top the power and simplicity of cost as a predictor.
In every single case, across every single type of investment, the least expensive mutual funds outperformed the most expensive mutual funds.
Cost won out 100% of the time.
What This Means for You
This was a surprising result, and in many ways it’s counterintuitive. We’re used to paying more for higher quality things, and this flies in the face of that conventional wisdom.
But in other ways it makes complete sense. After all, every dollar you pay in fees is a dollar that isn’t being invested in your future and isn’t taking advantage of decades of exponentially compounding returns.
Regardless, it’s the truth. Lower cost investments tend to perform better than higher cost investments. It’s the surest way to predict which investment will provide the best returns.
And that means that when you’re choosing your own investments and you’re deciding between two or more similar options (e.g. two different S&P 500 mutual funds), the very first thing you should look at is how much each fund costs.
The less you have to pay, the more likely you are to get the results you want.
As Morningstar wrote in their report: “Investors should make [costs] a primary test in fund selection. They are still the most dependable predictor of performance.”
Investment Costs to Watch Out For
All of that brings up one very obvious question: How do you know how much an investment costs?
There are actually a number of different fees to watch out for. Here are some of the major ones you’ll encounter.
Expense Ratios
Every mutual fund or exchange-traded fund (ETF) that you invest in will have an expense ratio that covers the cost of running the fund. It’s expressed as a percentage because the fee is calculated as a percent of the money you have invested in that particular fund.
Expense ratios range anywhere from 0.05% in the best cases to 2.00% and above in the worst. And since fee this is taken out of your investment every single year, you’ll want to do everything you can to minimize it.
12b-1 Fees
A 12b-1 fee is usually already included in the expense ratio, but it’s also listed separately because it’s technically a cost of marketing the fund as opposed to a cost of running the fund.
Since you really don’t care whether the fund is marketed to other people, you should probably try to avoid these fees.
Sales Loads
Sales loads are a fancy way of saying commissions. Sales loads can be charged either when you buy a mutual fund or when you sell it, and they are paid out to the people who sold you the fund in the first place.
These loads are charged in addition to the mutual fund’s expense ratio, which means that loaded funds are extra costly. The good news is that it’s easy to find funds that don’t charge these fees.
Quick note: When you work with a financial advisor who doesn’t charge you anything, they’re typically making their money by selling you investments with sales loads. And yes, that money is coming directly out of your pocket, so you are paying them — even if it doesn’t feel like it.
Trading Fees
Some investment platforms charge you to make trades. That is, you’ll pay them a small (or large) fee whenever you buy or sell an investment, including ETFs and mutual funds.
It can sometimes be worth it to pay these fees in order to get access to certain funds or features, but it’s also fairly easy to avoid them by using an investment company like Vanguard or Schwab.
Internal Fund Fees
Mutual funds and ETFs incur fees through their own internal trading activity that you have no control over. After all, they have to buy and sell their investments, too, which means they run into trading fees, taxes, and the like. All of these reduce the overall return of the fund.
There’s no direct way to measure this, but Morningstar calculates something called a tax cost ratio that attempts to quantify it. The lower the ratio, the more tax-efficient the fund is.
You can also look at a mutual fund’s turnover ratio, which measures how often a fund trades in and out of different investments. The lower the ratio, the less likely the fund is to incur these costs.
Management Fees
Your 401(k) might pay an advisor to manage the investments for them. Or you might have a financial advisor yourself who charges you a fee for managing investments.
A good financial planner can be well worth the cost, but it’s still a cost that needs to be factored in and considered carefully.
Administrative Fees
Does your investment account charge you an annual maintenance fee? Does your 401(k) charge you bookkeeping or legal fees? These are the kinds of administrative fees that might seem small, but again can add up quickly.
Taxes
We all have to pay our fair share of taxes, but you certainly don’t have to pay more than your fair share.
Using tax-advantaged accounts like 401(k)s and IRAs can minimize the amount of taxes you have to pay. And if you’re investing within a taxable account, you’ll want to be careful about making too many trades that force you to pay taxes on the gains.
For more on tax-efficient investing, this is a good resource: Principles of tax-efficient fund placement.
You Get What You (Don’t) Pay For
John Bogle, the founder of Vanguard, is famous for his twist on an old saying: “In investing, you get what you don’t pay for.”
The research bears that out. Lower cost investments perform better than their higher cost counterparts. It’s an easy way to improve your chances of investment success.
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.
The post A Surprisingly Easy Way to Predict Future Investment Returns appeared first on The Simple Dollar.
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