A funny thing happened when Morningstar performed a study on whether expense ratios or Morningstar “star” ratings are better at predicting higher future mutual fund returns. Expense ratios won. Russel Kinnel, Morningstar’s director of mutual fund research and study author, wrote about the study results on Morningstar and these quotes sum it up:
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. […] Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.
The study didn’t look very far back, but it probably couldn’t because Morningstar keeps trying to tweak its rating system into something that… um… works. 😉 So they looked at the star ratings and expense ratios from mutual funds from 2005 through 2008, and then tracked their progress through March 2010. Funds were categorized into five broad asset classes: domestic stocks, international stocks, balanced, taxable bonds and municipal bonds.
The Morningstar rating system didn’t do awful. But considering that expense ratios are one single number, and Morningstar has millions of dollars available to make their rating system work by crunching historical data and take into account whatever multiple factors they want, it must be pretty depressing for them.
Heck, one of those recent tweaks was specifically to factor in expenses as part of the rating system. In the end, Morningstar ratings are still primarily based on past performance. Another quote from the article:
Perhaps the most compelling argument for expenses is that they worked every time–because costs always are deducted from returns regardless of the market environment. The star rating, as a reflection of past risk-adjusted performance, is more time-period dependent.
Is it just me, or does “time-period dependent” sound a lot of like “it works sometimes, except when it doesn’t”?
Investing based solely on past performance is as someone said, “like driving down a winding road using only your rear-view mirror”. Using the same driving analogy, I feel that investing with very low costs is like racing with a constant breeze at your back. (Or more accurately, all your opponents are driving into a constant headwind.) Over time, this relentless advantage will lead to above-average returns.
Next time you see an mutual fund ad touting their 
or 
ratings, just ignore it.
More media coverage: Associated Press, NY Times, CBS MarketWatch
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People put way too much emphasis on expense ratios. If all funds were the same, then of course a lower expense ratio is good. But all funds are not the same. For example, Fairholme (FAIRX) has a “high” expense ratio of 1% and is NON-diversified, yet it beats the S&P every year and is pretty much the #1 U.S. stock fund in 1, 3, 5, & 10 year time periods. Typical wisdom isn’t working anymore and hasn’t for a while (i.e. Bonds have actually outperformed stocks in the last 3, 5, 10 & 20 year time periods, yet common wisdom says invest in stocks.) People should think for themselves instead of jumping on the low expense ratio, index fund, invest in stocks approach to investing. I know some people won’t want to, and an index fund is therefore fine for them, but anyone reading this blog probably takes an active interest in investing.
I would like to thank Morningstar for what the NY times called ‘an act of radical and admirable transparency’. I could not agree more.
As surprised as i was about the finding here (because although I thought expenses were a big deal, I thought that star rating was equally important), I was even more surprised that Morningstar itself was the source.
Thanks for writing about this!
I agree! That’s quite a big action for them to take to admit that their own ratings don’t have a strong indication for performance. I have always taken the Morningstar ratings with a grain of salt, as I was thinking they are similar to the analyst ratings that are placed on stocks. Those ratings can be affected by investment banking sponsorship as well.
OK, now that Morningstar has stumbled on this information (aren’t they like the LAST?) shouldn’t they update their rating system such that low cost funds rise to the top??
Seriously speaking, to come to this realization and do nothing is actually worse than being ignorant of it. One would expect that now armed with this new information Morningstar will adjust their star ratings such that expense ratios play the biggest role in their rating system.
Reminds me of movie star ratings…
Old news, here’s much of the same from 2000 (click my name to follow to the reference from which these quotes were found):
St. Louis Post-Dispatch, November 10, 2000 from Morningstar’s Director of Research, John Rekenthaler:
“There’s actually not much difference between mid-ranked funds and top-rated ones. Three-star, four-star and five-star funds have been found to perform pretty much alike.”
In the Vanguard, Autumn 2000, from the same guy:
“…to be fair, I don’t think that you’d want to pay much attention to Morningstar’s star ratings either.”
— Steve Bonds
Erik — You obviously work in the industry and are paid off of the expense fee. Financial planner? I’ll take my low cost funds against any high expense fund any day. Bill Miller proved that you can’t do it forever.
Bob –
Nope, I don’t work in the financial industry. Just trying to make a contrarian viewpoint. I am all for low-cost funds – however, there are a few no-load, actively-managed funds with brilliant management that have consistently outperformed the market. Not a lot of funds, but at least a few.
Eric,
I completely disagree that “people put way too much emphasis on expense ratios.” I would argue the exact opposite. I think people do not put enough emphasis on expense ratios.
It has been proven many times that the only thing you know for sure looking toward the future is that a low expense ratio (if the fund offers that) provides are large advantage over any similar funds with higher expenses and/or sales loads.
The one example you provide is hardly evidence to the contrary. That fund also often holds a significant stake in Berkshire Hathaway. It also bounces around from year to year from “large growth” to “midcap” to “large value.” Good luck if you own a significant stake in this and are trying to use specific ratios for asset allocation. Good luck hoping for significant outperformance in the future. This doesn’t even consider its ballooning asset base. I’m sure you would be much better off simply owning BRKA or BRKB.
I have a great idea; let’s all chase performance. NO wait, we tried that. It doesn’t work, at least not long term.
Jack –
As I said, low expense ratios are an advantage – IF the funds are the same. I was making the case that there are a few funds with stellar managers that consistently outperform the market. Also, I don’t think that buying a fund based on 10-year performance is chasing performance. One year or three year, yes, but not 10-year.
Chasing performance is eventually, if not immediately, self-defeating. Even if there is a genius fund manager who consistently beats the market, if you give him too much money to work with, he will eventually run out of above average places to invest it all. On the other hand there are probably some people who are just very lucky. The trick is not to mistake luck for genius.
Stick with the low-cost funds unless you are sure that you are a lucky genius!
Erik – two questions… (1) how would I have known to buy FAIRX in 2000? (2) What fund should we buy for guaranteed market-beating returns from 2010-2020?