Fees and Mutual Fund Performance

I am copying paragraphs from an article on the Morningstar website concerning the impact of fees on mutual fund performance. You would want to think that if you are paying more money for a mutual fund that you would be getting a higher return. Unfortunately, this is not true with the difference in performance being the additional cost of the fees. The more you pay in fees the worse your performance.

This fits nicely with yesterday's article, "Excessive Fees" that funds with high fees should be avoided because you are only paying a sales charge like a sales tax. This article quantifies the data. Let me know if you have a question.
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How Expense Ratios Performed
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. In every single time period and data point tested, low-cost funds beat high-cost funds.

Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.

For example, the cheapest quintile from 2005 in domestic equity returned an annualized 3.35% versus 2.02% for the most expensive quintile over the ensuing five years. The gap was similar in other categories such as taxable bond, where cheap funds returned 5.11% versus 3.82% for pricey funds. That same relationship held up dependably in the other time periods we measured. For 2008, the cheapest quintile of balanced funds lost 0.04% over the next two years, while the most expensive shed 1.13%.

The gap was also impressive as measured by the success ratio because high-cost funds are much more likely to have poor performance and be liquidated or merged away. For the 2005 group, we found that 48% of domestic-equity funds in the cheapest quintile survived and outperformed versus 24% in the priciest quintile. Put another way, funds in the cheapest quintile of domestic equity were twice as likely to succeed as those in the priciest quintile. It was a similar story in other categories, although in munis the advantage was greater than 6 to 1. The same basic relationship held up for the other years we looked at. Although I think of expense advantages as taking a long time to compound to your advantage, even the 2008 group saw low-cost funds with nearly a 2 to 1 success advantage.

Given that performance edge, you won't be surprised to hear that low-cost funds also produced better risk- and load-adjusted performance as measured by the star rating. For example, the 2005 group enjoyed a subsequent 3.23 average star rating compared with 2.66 for the priciest quintile in domestic equity. The edge grew in taxable bonds to 3.34 versus 2.3. The edge held up for predicting three-year ratings for the 2006 and 2007 groups.

Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you'll be on the path to success.