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Fund costs give you the best clue for outperformance – Morningstar

The cheaper a fund is, the better the chance it outperforms its peer group, a study by Morningstar has shown.


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Morningstar’s study, focusing on US-domiciled active funds, found that those funds with lower expense ratios consistently outperform their more expensive peers across all asset classes Morningstar looked at (US equity; global equity, US bond and balanced funds). This was the case over both three- and five-year periods.

US equities showed the strongest relationship between fund costs and return. The funds in the lowest-cost quintile had an annualised return of 10.91% over five years, compared to just 8.88% for the highest-cost quintile. This is actually higher than the average cost difference between the lowest- and highest-cost quintiles (see chart).


ETFs – still the better option?

However, the returns of the funds in the lowest-cost quintile (which averaged 0.65%) were still lower than those of the S&P 500, which averaged 12.6% a year over the period. This suggests that buying an ETF would have worked even better than going for a low-cost fund.

Active US equity funds overall have struggled to outperform their benchmark recently. Since more expensive funds tend to be more active than their cheaper peers as well, as Morningstar suggests in its study, a possibility is that so-called benchmark huggers are well-represented among these lowest-cost funds advocated by Morningstar.

Russel Kinnel, manager research director at Morningstar, admits many of these lowest-cost funds actually could have a low active share. “It’s possible there is a link because successful funds will often have larger portfolios and lower costs,” he says. However, being a benchmark hugger isn’t necessarily a bad thing, according to Kinnel. “Active share has no predictive power and many diversified funds have been able to beat their benchmark. High costs are a bad idea no matter the portfolio.”

The best approach would therefore be to screen for costs first and then see whether an ETF or an active fund suits better to reach your investment goals, says Kinnel. “Our research continues to find that fund fees are a strong and dependable predictor of future success.”

Click here to read Morningstar’s study.