/ 20 August 2010

Costs are the best predictor of performance

The US mutual fund industry has been rocked by a research report released by Russel Kinnel, who happens to be the director of mutual fund research for Morningstar.

The report “finds that ‘expense ratios’ [costs] are still the most dependable predictor of mutual fund performance” and that “investors should make expense ratios a primary test in fund selection”.

Rather embarrassingly for his employer, Morningstar is commonly associated with its Star Rating system for assessing mutual funds’ performance. A five-star rating means that the prospects for future performance (and survival) of a mutual fund is significantly better than for a one-star rated fund.

The Kinnel Report surveyed five broad asset classes — domestic equity, international equity, balanced, taxable bond and municipal bond — mutual funds in its database over the period 2005 to March 2010 in the United States, looking at total returns over that period. From this sample, it compared the funds given five-star and one-star ratings by Morningstar with the expense ratios of these funds. It found that expense ratios outdid the star rating system 58% of the time in predicting better total returns in future.

Expense Ratios
The Kennel Report examined the expense ratios of the five classes of mutual funds over the past five years and found that “in every asset class, over every time period, the cheapest quintile funds produced higher total returns than the most expensive quintile”.

The report concludes: “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.”

The report by Morningstar’s director of research has been widely reported in the US and has been hailed by many in the low-cost passive investment industry, such as the providers of ETFs, as a key victory for the exchange-traded fund industry.

Morningstar’s Star Rating system has been often singled out as a core factor in building the myth that you can predict high performance by actively managed mutual funds. Now, the Kinnel Report suggests that you might as well pick the lowest cost funds to predict future performance potential.

Many analysts believe that what holds good for the US investment industry is equally applicable to South Africa. In South Africa’s collective investment scheme industry there is a wide dispersion of expense ratios. ETFs, such as the BIPS 40, have a Total Expense Ratio (TER) of 0,21% per annum. This compares with an average 1,70% TER for unit trusts in the same sector of the market.

Some high-flying marque unit trusts have TERs of 4% or more, once performance fees are taken into account. Do these high-cost funds necessarily offer better performance than low-cost funds?

We leave you with one last quote from the Kinnel Report: “In every single time period and data point tested, low-cost funds beat high-cost funds.”

The Kinnel Report

  • Mike Brown is MD of EtfSA, an exchange-traded fund platform
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