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January 26, 2016

What’s the secret to picking outperforming funds?

While this sounds like a click-bait headline, empirical studies have actually shown that there is one (and only one) indicator that has a high probability of predicting future category winners. It is not past performance, not the number of stars in the Morningstar fund rating or the size of the fund but costs. Put simply, the lower the costs, the higher the probability that a fund will end-up in the top quartile over the long-term.

Fees matter

The following table shows the success rate by category, i.e. the percentage of actively managed funds that generated a return in excess of the equal-weighted average passive fund return over the period. We can draw three important conclusions from this study:

  • Investors would have significantly improved their odds of success by favouring cheaper funds.
  • On the other hand, investors choosing funds from the highest-cost quartile would have significantly reduced their chances of success. High fee does NOT equal better (higher performing) products
  • Actively managed funds tend to underperform their passive counterparts and the underperformance increases over longer time horizons.

Morningstar2

It makes no sense to defend active investing against index investing, or vice versa. As Morningstar correctly writes „a singular quest should link active and passive investors: low costs“.

But where should investors draw a line? We categorically rule out any funds that charge more than 1.0% per year. Performance fees are equally a no-go area! Currently the average fund fee of the products we use in our clients’ portfolios is around 0.1% to 0.5% – and we expect this to continue to drop over time.

Morningstar Magazine August/September 2015

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