(PUB) Investing 2016

October 2016 Vol. 25 No. 2

FundInvestor Research and recommendatio s for the s riou fund investo

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The Battle of Costs vs. Performance

performance had an expense ratio averaging 2 . 17% , but returns were a robust annualized 6 . 95% . So, how did the next 10 years go? The funds that started with low costs and poor returns went on to enjoy a 7 . 41% annualized return compared with 5 . 46% for those formerly high-performing pricey funds. In fact, the cheap laggards produced the highest returns of any of the 16 groups, while the pricey sports cars had the worst of any group. The return figures actually understate the difference because high-cost failures were more likely to be liquidated by the parent company because of subse- quent periods of poor performance. This is why I use success ratios in conjunction with returns. What happened? Low costs delivered the goods and high costs hurt performance. We read too much into past performance, but the data shows we should pay more attention to expense ratios. Expenses are a constant whose impact compounds over time. Jack Bogle calls it the “relentless rules of humble arith- metic.” In addition, a smaller part was played by the way that markets rotate favor so that lagging sectors and strategies recover while strong sectors and strate- gies revert to the mean. Thus, those funds with lagging five-year returns often came back to beat the funds that won the previous round. I’d also call your attention to the success ratio. That’s a figure that tells you what percentage of a group of funds survived and outperformed over the next period in question. Here we see a 38% success ratio for the cheap laggards versus just 9% for the pricey funds. This tells me that the cheap funds not only outper- formed but also were much more likely to survive than the pricey return champions. Only 9% of those seem-

RusselKinnel, Director of ManagerResearch and Editor

Fund Reports

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“Who cares what a fund charges? If a fund has great returns, then I know it was able to overcome its fee.” I see comments like this one just about every time I write about the predictive power of fees. There’s a certain logic to it, but the problem is one of persis- tence. Fund expense ratios don’t tend to change much, whereas performance changes a lot. I’ve shown how fees predict success, but this time I wanted to go one step further and look at the combination of expenses and past performance. Would you rather own a low-cost fund with poor past performance or a high-cost fund with great past performance? Novice investors would typically say the latter, but the former is the better choice. Hands down. I went back 10 years and grouped funds into expense- ratio quartiles relative to category and trailing five- year-return quartile by category. (I used the past five years because that’s the time period investors seem to rely on most.) Then I combined the data so that I had fee quartiles grouped by past returns. That left me with 16 groups of funds: the cheapest funds divided into quartiles by return, the second-cheapest funds in return quartiles, and so on. See the table on Page 2 for the whole picture. At the end of 2005 , the U.S. equity funds in the cheapest quartile but with returns in the worst quar- tile had an expense ratio of 0 . 73% and an average five-year return of negative 1 . 92% annualized. The funds in the priciest quartile but with top-quartile

Harbor Capital Appreciation Matthews Asian Growth & Income PIMCO High Yield Vanguard Tax-Managed Capital Appreciation

Morningstar Research

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Are Large Caps Overpriced?

The Contrarian 10 Cheap Medalists Due for a Rebound

Red Flags

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Watch Out for Downgrades

Market Overview

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Leaders & Laggards

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Manager Changes and News

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Portfolio Matters

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The Usual Suspects Might Not Help When Rates Rise

Tracking Morningstar

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Analyst Ratings

Income Strategist 20 Funds That Use Everything but the Kitchen Sink to Produce Income

Changes to the 500

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FundInvestor 500 Spotlight

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Follow Russ on Twitter @RussKinnel

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