Many investors will be surprised to learn that the best predictor of a mutual fund’s future success is not past fund performance, investment manager selection, market timing, sector rotation or fundamental analysis – it is low fees.
Morningstar Inc. published an article this week showing the results of their recent study where they found that an investor using low fees as a guide would have better results than using other predictors including Morningstar’s own star rating system.
They went on to report across all asset classes during various time frames from 2005 through March of 2010 that low-cost funds had better returns than high-cost funds.
As an example, in the domestic equity funds arena, those funds in the cheapest quintile during 2005 had average annualized gains of 3.35% over the next five years. Those similarly rated funds in the most expensive quintile had returns of 2.2%. On a $50,000 investment the difference for the 5 years would be $3,208 and in ten years $8,320 and in 20 years $19,379.
The most expensive funds tend to be actively managed. The least costly funds tend to be index funds and are passively managed. This study seems to confirm that using low-cost index funds would generally provide higher returns than using more expensive actively managed mutual funds.
The Department of Labor knows that high fees erode 401(k) plan growth and this study confirms the rational of the Departments recent proposed rules that would encourage plan participants to utilize low cost index funds rather than the actively managed funds that the financial services industry continues to push.