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How Expense Ratios and Star Ratings Predict Success

  08/23/10 08:26, by Len, Categories: Personal Financial Management, Investment Management, Retirement Planning, Money Markets, Risk Management, Property Investment

Articles by Russel Kinnel in Morningstar Fund Spy

About the Author:
Russel Kinnel is Morningstar's director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains.

Summary:
We test the ability of expense ratios and star ratings to predict funds that will survive and beat their peers. We've run some fresh data on expense ratios and the Morningstar Rating for funds.

I'll share the details on who, what, and when, but first a few grabbers. How often did it pay to heed expense ratios? Every time. How often did it pay to heed the star rating? Most of the time, with a few exceptions. How often did the star rating beat expenses as a predictor? Slightly less than half the time, taking into account funds that expired during the time period.

In examining the expense ratios and star ratings, I settled on three key measures that, to me, are closest to investors' bottom lines and help cut through all of the clutter.

Success Ratio:
While total returns are nice, they are not the whole story. Mutual fund companies kill off their funds at a rapid rate--thus, sweeping mistakes under the rug. However, your losses are just as real if your fund is liquidated. If there's a destruction bias for a data point, then you want to factor that in. The success ratio tells you what percentage of funds in a given group survived and outperformed their peers. After all, that's what success really is. Anything short is a failure; yet too often, investors and the press act as though total returns are the same thing as the success ratio. This is the strongest of the three measures because it is not affected by survivorship bias.

Total Returns:
Everyone wants to know how any measure works at predicting total returns. Because equal proportions of each category are given 5 stars and 1 star, one can safely sum up returns across categories to see how the measure has done for an asset class as a whole.

Subsequent Star Ratings:
The star rating is a measure of risk- and load-adjusted returns, so naturally I want to know whether the star rating is able to predict future risk- and load-adjusted returns. Investors have long handled lower-risk funds better than higher-risk funds because lower-risk funds don't trigger strong feelings of fear or greed. Thus, lower-risk funds with slightly lower official returns actually led to better results for investors than high-risk, high-return funds.

How Expense Ratios Performed:
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. To see the results, click here.

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.

Read the whole article here.

Read the RSA take on this research by Mike Brown, Managing Director, etfSA.co.za

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