My firm’s most-recent analysis of 46,000 funds again confirmed a simple truth in portfolio construction: Controlling costs works better for managing a client’s portfolio than trying to predict performance. In fact, costs and fees are the most effective tool for predicting future performance. When comparing funds of the same asset class and investment style, past performance is uncorrelated with future performance. But current costs do predict future performance.
As many researchers in academia and industry have found over the years, cost is the single most reliable predictor of future performance. Morningstar reported that expense ratio is a better performance predictor than its own star ratings.
But few investors have a full command of all the costs of owning funds and the downsides of higher costs. In addition to loads and other explicit transaction costs of buying and selling funds, there are three ongoing costs that fund investors and their advisors need to consider: explicit management fees, disclosed in the expense ratio; portfolio trading costs, which are largely opaque but can be estimated from the reported turnover ratio; and taxes on distributions in taxable accounts.
None of these costs are entirely avoidable, but all have deleterious effects on the investor’s wealth and can be controlled to some degree. All can be estimated from widely available data and should be assessed by an advisor when deciding which funds to add, retain, or sell in a client’s portfolio.
There are several empirically proven upsides to investing in less costly funds. Relative to their more expensive peers, inexpensive funds have higher average returns, lower volatility, greater chances of beating their index, lower chances of significantly underperforming their index, and a lower probability of being liquidated or merged into another fund. While superior performance has never been shown to be predictably repeatable, fund costs generally persist – a fund’s expense ratio and rank relative to other funds’ expense ratios are stable over time. The same holds true for fund turnover ratios and the resulting trading costs, and for tax efficiency relative to comparable funds.
For sure. It's pretty well established that low-cost passive index funds, constructed into the right mix for each particular person/situation, haven't ever and will likely never be beat over the long haul by active/managed funds. Your strategy depends on your investing objectives of course, but for most folks it's retirement, college savings, and basic expensive life events like that.
