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Confirmation That Costs Do Matter

New research shows how investors can dramatically improve their outcomes by buying cheaper funds.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar's analysts often discuss the importance of looking for mutual funds with low costs. Joining me to discuss some research that underscores that point is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, in your latest issue of Morningstar FundInvestor you took a look at the connection between costs and subsequent performance. I want to talk about that. It's a topic that you've revisited over the years. Let's start with how you measured funds' subsequent success. You look for something called the success ratio. Let's talk about what that is, and why that's a little different than looking at how funds performed, simply?

Kinnel: That's right. You can look at returns and that's still helpful, but the problem with only looking at returns is you generally have survivorship bias, and survivorship bias is an important issue with fees because lower-cost funds are much more likely to survive than higher-cost funds. So, success ratio is a way of folding those funds that got killed off back into the performance. And the way I do that is success ratio tells you what percent of funds in a given group survived and outperformed. And because I think that's really how we think about it; I'm not going to feel real happy about the outcome if a fund doesn't do both, and so by factoring that in I'm giving you--you can come up with a percent of how many funds actually led to good results within any given group.

Benz: In all of your studies over the years you have pointed to there being a very strong connection with low costs and future success as you measure it, and high costs a low rate of success. Let's talk about kind of the headline findings as you revisited the data recently.

Kinnel: That's right. Once again, it turns out costs do matter and what's really powerful I think as you look at how big the impact is, so for instance, the cheapest quintile of equity funds over the five years and in 2015 had a 62% success ratio versus 20% for the priciest quintile. Meaning, you are three times more likely to be successful shopping in the cheapest bin than the priciest bin. And what's also striking is just how consistent that is. Look at any time period, look at any peer group, asset group and it works and almost always it's that same stair step; so the cheapest quintile does better than the next cheapest, which does better than the middle, and so on. So, it's really a remarkably consistent indicator of performance.

Benz: So, even if I look at a fund and it's not the most expensive in its peer group, it doesn't have a 2% expense ratio or something, but it's still pricey relative to its peers, when you look at the data, the deck would be stacked against such a fund.

Kinnel: Definitely. These funds are just poor or bad. As Jack Bogle likes to say, you get what you don't pay for. So, consistently, low fees are a better place to invest.

Benz: So, you mentioned, kind of, when you look at this asset class by asset class or category by category, I'd like to drill into that a little bit because I think some investors operate with the notion that, well, in certain categories it's OK to tolerate a higher expense ratio, maybe a small-cap fund or a really volatile asset class like emerging markets that there is so much going on that that expense ratio may not be that impactful.

Kinnel: Yeah, the data really don't support that. It's just if you're paying more in emerging markets or small caps, you're still hurting your chances of success just the way you are in fixed income. And I think one of the reasons is the fee range is even bigger in those pricier categories so that maybe in fixed income moving up one quintile, maybe that only saves you 10 basis points; in emerging markets that might save you 30 [basis points]. So, that's one reason. But I think it's just the return volatility in one year to the next is going to be obviously much greater. So, for a single year [in] a really volatile category, yes, fees are going to be a less important component, but over time, that tends to wash out and the impact of fees just grows as your investment compounds.

Benz: And you said by time period it really doesn't matter, either. So, I think investors might naturally think, well, those high costs naturally hurt me in some sort of losing market environment but my fund may make it up on the upside. But you really don't see any thesis there either?

Kinnel: No. The time period we looked at this time was 2010 to 2015, great time to be in the market, and it still was just as powerful as ever. So, there is always a good pitch for why you should pay for higher-cost funds, but it's rarely worth believing that pitch.

Benz: Let's talk about how investors have been allocating their dollars. We have, in fact, maybe seen the triumph of something really rational where we've seen investors choosing low-cost funds, right, when you look at flows?

Kinnel: That's right. Money is consistently flowing into low-cost funds and I think individual investors, financial planners, really everyone involved in the investing process has become more aware of the importance of fees. So, I think we're really seeing that that consistently more and more money in the last, I don't know 10 or 15 years, we've seen that trend where money going into the cheapest quintile has really become a much--has grown and grown over the years.

Benz: OK. Russ, it's such an important point to pay attention to costs. Great to see some current research on the topic. Thank you so much for being here.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.