Low-cost funds outperform high-cost rivals – every time

All credit to www.telegraph.co.uk/finance/personalfinance/investing/7936244/Fund-charges-low-cost-funds-outperform-high-cost-rivals-every-time.html

If there’s anything in the whole world of fund investing 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 (the 20pc of funds with the lowest charges) produced higher total returns than the most expensive quintile.

For example, the cheapest quintile from 2005 in American equities returned an annualised 3.35pc, versus 2.02pc for the most expensive quintile over the ensuing five years.

The gap was similar in other categories such as bonds, where cheap funds returned 5.11pc versus 3.82pc 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 0.04pc over the next two years, while the most expensive shed 1.13pc.

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 48pc of US equity funds in the cheapest quintile survived and outperformed versus 24pc in the priciest quintile. Put another way, funds in the cheapest quintile of US equity were twice as likely to succeed as those in the priciest quintile.

For the 2005 group, we found that 48pc of US equity funds in the cheapest quintile survived and outperformed versus 24pc in the priciest quintile. Put another way, funds in the cheapest quintile of US equity were twice as likely to succeed as those in the priciest quintile.It was a similar story in other categories, although in munis [municipal bonds, a popular US investment] 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 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.

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