Investors do not have the ability to predict the future when attempting to select good mutual funds. But there is information available for predicting poor performance.
A popular yet incorrect way to choose a good mutual fund is to pick one that has done well in the past. This approach sounds logical but there is no supporting evidence that this works.
There is evidence, however, suggesting that the cost of owning a fund does strongly influence how well a fund will or will not perform. Your fund will probably underperform other funds if its fees are high.
The opposite is also true. Your fund is more likely to have better investment results if the fees are low. This information is not new but there is new evidence indicating that fees are critical when choosing which funds to purchase.
Morningstar is a large firm that tracks mutual funds. Their new analysis studied mutual fund performance from June 2008, just before the financial crisis.
They examined mutual fund performance for five years starting in 2008 and compared fund fees to their actual performance. At the same time they studied past performance for the previous three, five and ten years to see if that information could be linked to good performance.
The study’s results were clear. The best single predictor of good performance is low fees. Good performance is most definitely not related to past performance.
The Morningstar study examined 112 mutual fund categories and divided all of the funds into five separate sub-sections based on the costs of owning those funds. The least expensive group of American equity funds outperformed 56 per cent of their peers.
In the same category the most expensive funds in that category underperformed 74 per cent of funds.
The study compared the best fund track record as of 2008 and found that those winning funds did not continue with superior performance.
The only sign of continual good performance was in bond funds where their success was repeated. Success did not continue for equity funds.
There are two key pieces of information that investors can learn from this study.
First, past performance is not a good indicator of future performance. Sometimes good performance continues, but often it doesn’t. If a fund did well last year then lucky for those who owned the fund.
Will it do well in the future? This most recent analysis from Morningstar clearly suggests history does not provide any indication of future performance.
Second, we can learn from Morningstar that investing in mutual funds with lower expenses can be an excellent way to choose a fund. A fund’s expenses reduce the returns earned by the investor.
Lower cost funds means that more of what is earned by the fund goes to the investor instead of paying a mutual fund company higher fees.
We recommend investors review the costs of owning various mutual funds. This can be done with the relatively new disclosure document called “Fund Facts” where fees are clearly disclosed.
Also, companies such as Morningstar provide mutual fund details including management fees and other expenses.
Most investors own mutual funds and there are advantages to owning them.
We encourage you to understand mutual fund fees and know performance results will most likely be better if those fees are low.