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Morningstar Study: High Mutual Fund Fees are Bad for Investment Performance

For years we have been preaching to our clients about the importance of avoiding mutual funds with high expense ratios and those that charge a ‘load’ or commission. We have always recommended funds from Dimensional Fund Advisors (DFA) which typically have expense ratios that are 80% less than the typical mutual fund. (i.e. about .3% for DFA and about 1.5% for the average mutual fund)

A new Morningstar Study, How Expense Ratios and Star Ratings Predict Success found that “In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”  The study did look at their own star rating system and found some success in the system; but the article concludes by stating emphatically, “Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.” (editor note: emphasis on ‘primary’ was added by the author of this blog)

Even the Department of Labor (DOL) has cautioned 401(k) investors regarding high cost funds and the erosion of their accounts due to these high fees:

“Assume that you are an employee with 35 years until retirement and a current 401(k) balance of $25,000. If returns on investments in your account over the next 35 years average 7% and fees and expenses reduce your average returns by 0.5%, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5% however, your account balance will grow to only $163,000. The 1.0% difference in fees and expenses would reduce your account balance at retirement by 28%.”

This is a stunning example of how a small difference in costs can add up over a long period of time. This is why investors should make the costs of a mutual fund a primary test in choosing an investment.

Other studies have shown that the Morningstar rating system is quite suspect in its predictive behavior. All one needs to do is google ‘Beware of the stars + Morningstar’ for plenty of evidence. Our recommendation to our clients and all investors is to construct a risk-appropriate, globally-diversified, tax-efficient portfolio using low-cost, passively-managed funds like those from DFA.

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