Learn How to Find the Best Performing Mutual Funds
Morningstar is a research company that ranks mutual funds. Want to know what they say about finding the best performing mutual funds? Their research shows that funds with the lowest fees are the best performers.
Research Shows Low Fees Indicate Best Performing Funds
In the Wall Street Journal article Low Fees Outshine Fund Star System, Morningstar's director of fund research says fees "have proven to be the strongest predictor out there." This comment stands out because Morningstar has their own proprietary ranking system for mutual funds, with funds having a one star all the way up to a five-star rating. The more stars, the better the fund. In the Wall Street Journal article, the director went on to say that relative to looking for low fees "The stars system, as a measure of past risk-adjusted performance, is going to be a little more limited."
Another article, Best Predictor of Mutual Fund Performance, states that “expense ratios are the strongest predictors of performance. In every single time-period and data-point tested, low-cost funds beat high-cost funds. You would think you would better quality if you are paying more, so why is is that higher fees seem to deliver lower returns?
Why Low Fees Result in Better Performance
As one famed economist professor (Eugene Fama) is known to say, “there aren’t hundred dollar bills lying around for the taking.” What he means is financial data is available at the click of a mouse, instantaneously, to millions – make that billions – of super smart people across the globe. They don't leave money on the table.
Actively managed funds have higher fees because they employ analysts to scour the data, and interview management teams of the companies the fund is thinking about investing in. It costs money to pay all of the research staff, so to deliver higher returns this approach has to overcome its higher costs. Most of the time all of this research is not able to deliver superior returns when you compare the results to what you could have achieved by using a less expensive "passive investing" approach.
Passively managed funds simply pick a set of defined criteria and own the stocks or bonds that meet that criteria. For example, a large cap passively managed fund might own all stocks with a market cap greater than $10 billion. They don’t need to pay a lot of people to do this. Costs stay low. And the data shows this lower cost approach wins.
What to Watch Out For
I have frequently seen ill-informed financial sales people who are employed as a captive representative (meaning they can only promote the products of the company they work for), tell people the exact opposite of what is stated in this article above. I would like to believe that they are not intentionally lying. The higher performance of mutual funds with lower fees has been documented for years. If anyone tries to tell you differently, they are grievously misinformed.
You should also be cautious of the latest “hot fund” list. When you look back a few years later on the subsequent performance of funds listed on some publication's “best funds to own” list, most of the time you had better performance by owning a simple portfolio of index or passively managed funds.