Do Expense Ratios Matter?

Russell Kinnel, Morningstar’s director of mutual fund research, wrote an article on August 9, 2010, titled “How Expense Ratios and Star Ratings Predict Success.” It is a must read and can be found online at Morningstar by clicking on this link.

Morningstar examined five broad categories of mutual funds—domestic equity, international equity, balanced, taxable bond, and municipal bond—over multiple periods beginning in 2005, 2006, 2007 and 2008 and ending in March 2010. The funds were sorted into quintiles based on expenses and the performance of the cheapest funds was compared to that of the most expensive.

We have always preached that investors should focus on the things they can control—expense ratios, turnover (i.e., tax efficiency), diversification, and asset allocation. Therefore, it did not surprise me that Morningstar’s research showed that cheap funds outperformed their expensive cousins in every time period tested. Kinnel observed “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.”

Among both domestic and international equity funds, total returns in every time period were higher for the cheapest funds compared to the 5-star funds. Kinnel concluded by saying that “investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.”

All I can say is Amen!

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