A reader recently asked whether the expense ratio of a mutual fund or the fund’s performance was the most important factor when selecting an investment. It’s an important question. What’s the point in investing in a low cost fund if it underperforms higher cost funds?
Mutual funds report their performance net of expenses. So if Fund A reports a 15% return and Fund B a 13% return over a given time period, do we really care what each fund charged investors? Whatever the expenses, they have been factored into the returns, and Fund A wins. If life were only that simple.
Certainly if we could invest with hindsight, all we would care about is performance. Of course, if we could invest in hindsight, we’d all be long in Berkshire Hathaway (BRK) whose price has risen 7,000-fold (yes, 7,000-fold) since Mr. Buffett took over in 1965. Because we don’t know what the future holds, however, a fund’s expense ratio is a critical factor to consider when selecting a fund. I’ll explain why I believe the expense ratio is so important, and then I’ll throw some data at you to back up my view.
Expenses are one of the few variables investors can control
With investing, like life, there are some things we can control and some things we cannot control. For example, we can control whether we invest in actively managed mutual funds or index funds. We can control our asset allocation and pick funds that invest in the type of stocks that match our asset allocation plan. And we can control how much in expenses we are willing to pay for a mutual fund. We cannot control, however, performance. Given two funds with similar investing styles, why would we pick the more expensive fund? What would lead us to believe that the more expensive fund will outperform the less expensive fund? We are most likely going to rely on the past performance of the fund, because we have nothing else to base our prediction of future performance. And that would be a major mistake. A given fund my perform very well for a period of time, even a relatively long period of time. But if we rely on history, we should conclude that expensive funds cannot continually beat their competition by a wide enough margin to justify the high expense ratio.
Mutual fund performance over the past 20 years supports the low expense approach to investing
The top performing funds change from year to year. In fact, many of the top ten funds in one year, end up in the bottom quartile the next. These funds often cost the most, too. I decided to compare the top 10 performing mutual funds over the past 1, 10 and 20 years, and look at the expense ratios for those funds. Before looking at the data, my assumption was that the 1 year top performers would have, on average, a higher expense ratio than the 10-year top performers, who in turn would have a higher average expense ratio than the 20-year top performers. Why?
Think of the expense ratio as an anchor and mutual funds as swimmers. The bigger the expense ratio, the heavier the anchor. Some funds may be able to tread water for awhile, but eventually the heavier anchor of expenses will slow them down if not drown them. As it turns out, the data support this conclusion.
Data for the top performing funds over the past one and ten years was taken from Morningstar. Data on the top performing funds for the past 20 years was taken from an article by Richard Widows published on TheStreet.com in October 2007. The data show that expense ratios of the top performing funds decrease as the period of time increases. The average expense ratio for the 1-year top performing funds was 1.54, the 10-year top funds 1.34, and the 20-year best funds 1.00.
This data shows that over the long run, funds with lower expense ratios perform best. We do have to be careful, however, not to misinterpret the data. For example, some of the 20-year top performers have high expense ratios. And some of these funds have lowered their expenses as the funds have grown in size. But the fact remains that without knowing what the future holds, choosing low cost funds is a sound decision for long-term investors.
If you disagree, let’s hear about it.