We're fans of easy, "set and forget" investing. And that means investing in funds with low fees that don't eat into your returns. A study from Morningstar found that funds with low fees are generally more successful. Photo by Pictures of Money.
We've told you all about index funds and how they make investing easy and less scary. Another reason to love them? They're usually cheap. However, some investors argue that their low fees, or expense ratios, come at a price: You get lower returns over time. But Morningstar's study found that cheap funds actually perform better than more expensive, actively managed funds. It was enough for them to declare that "fund fees are a strong and dependable predictor of future success".
To gauge a fund's success, they looked at historical data and how much the fund earned over time. Using that number and several other performance factors, they came up with a success ratio to measure how well the fund did over time and what percentage of those funds survived and outperformed similar investments. Here's what they found overall:
We found that the cheapest funds were at least two to three times more likely to succeed than the priciest funds. Strikingly, our finding held across virtually every asset class and time period we examined, which clearly indicates that investors should keep cost in mind no matter what type of fund they are considering.
In one example, the five-year average return for US Equity funds with an expense ratio of 0.65 per cent was almost 11 per cent. Similar funds with a 2.2 per cent expense ratio only yielded 8.8 per cent.
Of course, you could make the correlation-causation argument here. Just because a fund is cheaper doesn't necessarily mean that's why it's performing better. However, there's an important relationship between performance and cost. And Forbes contributor John Wasik breaks it down:
Why are cheaper funds more likely to succeed? Managers aren't running up costs trying to (unsuccessfully) time the market in many cases. Their fees aren't devouring total returns. That's why I invest in them in my portfolios, including an array of Vanguard funds.
It's just another reason to go with low-cost fees in your portfolio, rather than actively managed ones. Over time, they earn a solid, steady return. For more detail, check out the press release below, and you can download the study from there.