Should Investors Use Low Cost Funds?

If a picture is worth a thousand words, when it comes to investing, the Callan Periodic Table of Investment Returns (See image below) is worth one million. Just a quick glance underscores the importance of diversifying your portfolio across asset classes (stocks vs. bonds), investment styles (growth vs. value), capitalizations (large vs. small), and equity markets (U.S. vs. international). The Callan Table also illustrates the six words that the Securities and Exchange Commission requires mutual fund companies to publish when advertising funds: “Past performance doesn’t guarantee future results.”

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Although it’s indisputable that there’s no pattern that you can use to predict future results and boost portfolio returns, investors persist trying to pick the next hot asset class. However, a new study from Morningstar finds their research time would be better spent looking for low cost funds in the asset classes that compose their portfolios. According to Morningstar, when fees are low, the odds are much greater that an overall investment portfolio will outperform its peers.

Russel Kinnel, the director of fund research at Morningstar, got right to the point in a recent interview, “I’ve found that low cost is the best single predictor of subsequent performance available. It’s definitely not past performance,” he noted.

Morningstar’s findings support how we construct portfolios. First, we make the allocation decisions and divide the portfolio between stock and bonds, growth and value, etc., according to each client’s risk tolerance, goals and time horizon. Then we look for low-cost, low-turnover, hyper-diversified funds within those asset classes.

Clearly, with fund selection, you don’t always get what you pay for.

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