A Lower Cost Mutual Fund Could Mean Better Performance

Despite the time spent picking funds based on past performance data seems to suggest there are better indicators of a funds potential future potential.

What are the most useful predictors of superior performance? The Vanguard Group recently published a client brief stating that the most useful metric was the expense ratio of a fund, followed by portfolio turnover.

Vanguard found that on average “for every 1 percentage point increase in expenses, alpha declined by 0.78 percentage point.”

Over periods of 5, 10, 15, and 20 years through 2010, the lowest (1st) quartile of actively managed funds consistently outperformed higher cost funds. Over longer periods of time the importance of paying low fund expenses can be seem as only 16% of funds in the highest (4th) quartile outperformed their index.

Source: Vanguard Group

Notes: Data reflect percentage of U.S. equity mutual funds that outperformed their style benchmark for periods ended December 31, 2010. Data include only funds that survived the respective 5-, 10-, 15-, or 20-year periods. “U.S. equity mutual funds” refers to all funds, including those focused on a particular style or market capitalization such as large growth or small value. Sector funds, specialty funds such as bear-market funds, and real estate funds were excluded from the list.

Sources: Vanguard calculations, using data from Morningstar, Inc., MSCI, and Standard & Poor’s. Style benchmarks represented by the following indexes: large blend—S&P 500 Index, 1/1/1990 through 11/30/2002, and MSCI US Prime Market 750 Index thereafter; large value—S&P 500 Value Index, 1/1/1990 through 11/30/2002, and MSCI US Prime Market 750 Index thereafter; large growth—S&P 500 Growth Index, 1/1/1990 through 11/30/2002, and MSCI US Prime Market Growth Index thereafter; mid blend—S&P MidCap 400 Index, 1/1/1990 through 11/30/2002, and MSCI US Mid Cap 450 Index thereafter; mid value—S&P MidCap 400 Value Index, 1/1/1990 through 11/30/2002, and MSCI US Mid Cap Value Index thereafter; mid growth—S&P MidCap 400 Growth Index, 1/1/1990 through 11/30/2002, and MSCI US Mid Cap Growth Index thereafter; small blend—S&P SmallCap 600 Index, 1/1/1990 through 11/30/2002, and MSCI US Small Cap 1750 Index thereafter; small value—S&P SmallCap 600 Value Index, 1/1/1990 through 11/30/2002, and MSCI US Small Cap Value Index thereafter; small growth—S&P SmallCap 600 Growth Index, 1/1/1990 through 11/30/2002, and MSCI US Small Cap Growth Index thereafter.

Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

1 Turnover is a measure of a fund’s trading activity. For this analysis, turnover was based on the lesser of the value of a fund’s purchases or sales divided by average total net assets, as reported by Morningstar for the period specified.

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