Our Insights

About personal finance, investments and markets.
November 21, 2016

Performance killer #1

Had enough of Trump? Back to investment advice, that will still be relevant 10 years from now… One of the most frequent questions we get from clients is whether there is a criteria that could help select future outperforming funds. Morningstar, an independent fund research firm, recently published a study showing again that fund fees are proven predictors of future success. The results are similar for the US and for Europe. If you are still paying an initial charge, a performance fee or an annual fee in excess of 1%, you are doing something wrong.

We understand investors’ obsession with finding the next hot fund, but what they should really do is comb through their existing portfolio and weed out all the high-fee, underperforming mutual funds. This is an easy and highly objective exercise that will help improve long-term returns.

Why fund fees are so important – costs are a good predictor of success

In July, Morningstar published a study on the European equity mutual fund landscape that mirrors what has been reported about US funds previously. The European study covered more than 4,000 funds from 2011-2015 and showed convincingly that there is a clear relationship between fees and probability of outperforming the benchmark. For the tests, Morningstar grouped funds into quintiles according to their fees. As can be seen in the following chart, the outperformance declines with a higher fee structure.

Morningstar

The study revealed a few more interesting points:

  • In the global equity large cap category (yellow, left), on average only 7% of the fund beat the MSCI World index. Even the cheapest and best performing quintile showed only a 15% probability of success. Put differently, >90% of the funds in this category underperformed – why anyone would choose to invest in active funds with such a low probability of success is hard to fathom.
  • In the European large cap category (green, middle) the picture is slightly better for actively managed funds, but even here, less than half of all the funds, even in the cheapest category failed to beat the benchmark.
  • In the Emerging Markets category (blue, right), the picture is a bit more mixed but the overall trend is the same. The more you pay in fees, the lower is in most cases your chance of long-term success.

Summary – you get what you don’t pay for

While we think that investors should take a variety of factors into account when choosing funds, the results show that fees are a strong and dependable predictor of success. The results hold across virtually every asset class, time period and geographic area.

The numbers don’t lie. My own portfolio is therefore full of low-cost index funds (ETFs), broadly diversified by geography, market cap and risk factors. We are using for our clients also mainly low-cost index funds as the core building block to manage their assets. Index funds allow us to gain exposure to certain asset classes and strategies in the most efficient way possible while considering the costs and risks involved at all times.

Even Warren Buffett recommends index funds for individual investors. Maybe you should use them too?

 

Sources:

http://www.morningstar.de/de/news/150033/kosten-und-performance-es-w%C3%A4chst-nicht-zusammen-was-nicht-zusammengeh%C3%B6rt.aspx

http://corporate1.morningstar.com/ResearchArticle.aspx?documentId=752589

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