Lower Costs = Higher Returns (Again) and Survivorship Bias

Whether you invest your hard-earned money in passive index funds or actively-managed funds, the more important thing is that costs matter. Every penny you pay in mutual fund expense ratios, sales loads, trade commissions, and financial advisor fees reduces your return. Even Morningstar, a company famous for their proprietary star rating system, looked at their data and admitted that expense ratios are the “most dependable predictor of performance” and should be the “primary test in fund selection”. I like to visualize high expenses as a constant, relentless drag that is almost impossible to overcome over long periods of time. You can play with this cost widget to see how much costs eat into returns over time.

Here comes more proof. I invest a huge chunk of my money in Vanguard funds, because they offer the best selection of low-cost mutual funds around. Every year, as they get more successful, my costs actually go down as they advantage of economies of scale. However, they also offer a large selection of actively-managed funds, one of which has been around since 1928.

Data from Lipper Ratings shows that over 80% of Vanguard funds (both active and passive) have outperformed peer funds in the same categories over the last 5- and 10-year period ending 6/30/11.

You’ll find that T. Rowe Price also touts the returns of their group of funds:

Not by accident, one of their tenets of investing is low costs:

Low-Cost, Active Management
We believe in actively managing our funds and pursue a disciplined process to individually evaluate every stock and bond we invest in. But we don’t believe it should cost a lot. We keep our expenses low, so your investment can go even further. We offer over 90 funds with no loads, no sales charges, and expense ratios below their Lipper category averages.

Survivorship Bias
Making the case even stronger, by hovering over the the Vanguard chart, you can see how many peer funds there were. Let’s just take the stock funds. For the 1-year comparison, there were 10,644 funds in their peer category. For the last-3 years, that drops to 9,207 peer funds. Last 5 years, 7,562 peer funds. Over the last 10-years, only 4,035 peer funds existed.

Where did all the funds go? Sure, some funds are new, but there were lots of new funds back in 2000 as well. The fact is that many older funds are unable to be compared today because they never lasted 10 years. Most likely, their performance was so low that they quietly closed down or merged with another fund. This is called survivorship bias, and means that existing funds did even better than these charts might indicate because of the dead funds that aren’t even included.