Some things bear repeating. In 2010, Morningstar published a study saying that when it comes to predicting the future results of a mutual fund, low fees are one of the best forecasters of success. This year, they said it again.
While investors should consider many factors when choosing funds, Morningstar found that fees are “a strong and dependable predictor of future success.” The May 2016 report evaluated the ability of fund expenses to project not only future total returns, but also load-adjusted returns, standard deviation and investor returns.
“We found that the cheapest funds were at least two to three times more likely to succeed than the priciest funds,” said Russel Kinnel, editor of Morningstar FundInvestor. “Strikingly, our finding held across virtually every asset class and time period we examined, which clearly indicates that investors should keep cost in mind no matter what type of fund they are considering.”
The chart below from Morningstar shows the sweeping advantage that low fees provide across asset classes. The blue bars on the left, for example, show the lowest cost U.S. equity funds succeeded three times as often as the highest cost funds. The term “success ratio,” according to Morningstar, answers the question, “What percentage of funds survived and outperformed their category group?”
While this might sound like a case for index funds, don’t be so sure. Despite the reputation passive funds have as being the cheapest option, numerous actively managed funds are also among the funds with the lowest fees.
And what’s more, a select group of these funds have a history of beating the index.
So How Do You Find Them?
As Morningstar said in its report, investors should consider more than just fees when weighing where to put their money. In addition to low fees, manager ownership and downside capture can also be important fund characteristics, according to research by The Capital Group.
Funds that include their own managers among their investors have tended to outpace indexes in the past, the research showed. The study, which used Morningstar data, states that the combination of these two characteristics – low fees and high manager ownership – can be helpful in selecting funds.
The chart below shows that funds with those two traits significantly improved success rates versus the index. They were also associated with greater average risk-adjusted returns.
Even the Securities and Exchange Commission recognized manager ownership as significant. The SEC requires that funds disclose how much each manager invested in his or her fund, and the information must be disclosed in the fund’s Statement of Additional Information.
Beyond fees and managers, a trait known as downside capture helps identify potential successful funds. Funds that share this trait — that is, don’t fall as far as the index during market declines — have been associated with a strong track record against indexes, the Capital Group study showed. Those that provide this resilience during downturns and experience less volatility can be especially important in retirement, when investors are taking withdrawals.
It’s no secret that evaluating funds is tricky. And past returns aren’t predictors of future success. But starting with a low-fee fund is a first step in the right direction. And finding funds with high manager ownership and low downside capture is the next.
“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,” Kinnel wrote. “In every single time period and data point tested, low-cost funds beat high-cost funds.”