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Page 1 of 3  Morningstar has recently explained how the level of reported fund expenses is the best reverse predictor of fund performance i.e. the higher the expenses, the worse the likely return. But reported expenses do not represent all fund costs. Without full information an investor considering an actively-managed fund manager who (hopefully) will beat the market is in a dilemma. He has no way of knowing by how much any particular fund manager must beat its benchmark index pre-fees and costs to produce a market-beating return. This first commentary looks at the Morningstar study, and introduces the (unlucky) thirteen different types of fees and expenses that fund investors can be hit with. In subsequent commentaries we will try to quantify the aggregate all-in, after-tax annual cost to  equity mutual fund investors; give a more detailed analysis of the 13 types of fund fees and expenses; and describe the profile of the ideal mutual fund (and ETF) from the perspective of minimizing aggregate fund costs.
Introduction
Retail investors can invest directly or through mutual funds or ETF’s. In making that decision costs are a key consideration. Figuring out the costs of direct investing are fairly straight forward. Figuring out fund costs and their impact on investor returns is not.
Morningstar report on fund expenses
The fund evaluation company Morningstar recently released a study or as PDF
doc.1762 on the relation between mutual fund expenses levels and investor returns in the USA. Here is how they proceeded:
We took a snapshot of star ratings and expense ratios from 2005 through 2008 and then tracked their progress through March 2010. We rolled up category level data into five broad asset classes: domestic equity, international equity, balanced, taxable bond, and municipal bond. We then measured total returns as of the end of March 2010 for the mutual funds that survived the entire period. For the success ratio, we included funds that were merged or liquidated, as well as those that survived, in order to calculate the number that both survived and outperformed. For the star rating, we recorded the five-year star rating for the data set from 2005, as well as the three-year rating. For 2006 and 2007, we recorded the ensuing three-year rating--meaning we measured the figure in March 2009 for the class of 2006 and the rating in March 2010 for the class of 2007. For the class of 2008, we don't yet have a star rating. For the purpose of this article, I focus on the gap between 1- and 5-star funds and cheapest and most expensive quintiles. NB- Although not stated, we believe the study used the MER as the measure of fund expense levels; more about MER’s later.
Their conclusion?
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. In every single time period and data point tested, low-cost funds beat high-cost funds. … Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.
But should we be surprised?
In most businesses, you pay more to get more. But in the mutual fund business, you get what you don’t pay for, or stated otherwise, less is better. The Morningstar study received considerable attention; see NYT editorial
or as PDF
doc.1763; Richards NYT
or as a PDF doc.1764; Hougan IndexUniverse
or as a PDF
doc.1765; Hale MarketWatch
or as a PDF doc.1766; a AbnormalReturn
video ; and in the WallStreetJournal
.
The Morningstar conclusions are not really news. The study in fact merely confirms previous studies; see for example a 2002 US study by Stephan Sharkansky of PersonalFund.com or as a PDF
doc.1767. And a 2005 study by Hocjachka or as a PDF
doc.1768 and a more recent 2008 study by Bauer and Kicken
(see in particular table 5) doc.1271 came to the similar conclusions for Canadian funds.
But if expenses are so critical, it should be easy to calculate them and select mutual funds or ETFs accordingly. But unfortunately, things are not so simple. In this first commentary we look at the different types fund expenses, fees and other deductions (which for convenience we sometimes simplify refer to as expenses or costs) faced by fund investors, the difficulties in computing them, their impact on fund returns, and some practical recommendations.
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