More on the Cost of Mutual Funds

We've talked about the role cost plays in determining the success of a mutual fund's performance. CNN Money tackled the same issue (and quoted the same Morningstar study) from a different perspective in a recent column. It started with the following question from a reader:

I'm trying to choose between two funds in my 401(k) that invest in the same sector. One has higher fees, but it also performs better. How can I tell if a fund's performance is worth the higher price?

Some of the highlights from CNN Money's answer:

I've been telling investors for years that they're better off sticking to low-cost funds whether they're buying them for a 401(k), IRA or, for that matter, any type of account.

Here's the bottom line: Whether it was domestic stock funds or international, taxable or municipal bond portfolios, low-cost funds beat their high-fee counterparts in every single time period tested in the study. Morningstar even concluded that expenses were a better predictor of a fund's future performance than its widely followed star-rating system.

But does that mean in every fund with lower expenses will outperform every other comparable fund with higher fees? Of course not.

Fact is, it's always hard to tell in the case of actively managed funds what's driving better performance. Is it low fees? Superior stock picking? A more aggressive or conservative strategy? Simple luck or randomness? Market researchers have debated such questions for years -- a recent paper takes on the luck vs. skill question directly -- and no doubt will continue to do so for years to come.

At this point, I think it's fair to say that managers who outperform due to true skill are few and far between and identifying them in advance is extremely difficult. For most investors I think distinguishing between luck and skill is essentially a guessing game, which is one reason I believe most investors are better off opting for low-cost index funds.

All else equal, the bigger the expenses, the higher the hurdle a manager has to overcome to keep pace with similar funds. And just because a manager has been able to clear that obstacle in the past, doesn't mean he or she will be able to do so consistently in the future. If anything, the odds are against it.

Lots to comment on here. My thoughts:

• I'll say it again, costs matter if you want to maximize investment returns.

• Low costs is one reason I invest using index funds.

• Another reason I invest this way because I agree with CNN Money, picking a fund/manager who can out-perform the market is difficult if not impossible to do on a consistent basis. And those who have a chance of beating the market have to commit so much time and effort (time I don't have to commit) -- and still they aren't guaranteed success!

• Whether anyone can pick a manager that beats the market or not (or can pick stocks that do better than the market themselves or not) isn't really the issue anyway. If you want to make the most of your investments, the most important factor is the amount of time you are invested. And since time (as well as amount saved) are factors you CAN influence (while return rate is something you can NOT influence/control nearly as much), isn't this what investors should be spending most of their time discussing (how to save more and do it earlier)?

Comments

[Bad_Brad]

The problem with index funds is that you are by definition overweighted in large cap stocks. I have no problem with index funds as part of a portfolio, in fact, to cover off the large cap domestic stock area, I will take an index fund over a managed fund any day of the week and twice on Sunday. But if you are only investing in index funds, you are not really diversified.

[LotharBot]

Brad,

That depends on what index you invest in. Vanguard's index fund listing includes 8 large-cap index funds, 4 mid-cap, 3 small cap, 4 bonds, 8 international, 1 sector (Real Estate index) and 1 balanced.

[Apex]

@Bad_Brad,

There are large cap index funds, mid cap index funds, small cap index funds.

So if you buy 1/3 of each you are not over-weighted in large cap.

Now granted you are over weighted in the largest of the mid cap and the largest of the small cap within each of those indexes but given that the small cap is already stocks that are 100-500 times smaller than the largest large caps you are doing pretty good at avoiding having too many large companies. And do you really want to have equal weighting of the smallest of the smallest companies. Those companies tend to be the riskiest so having a little less of those in a weighted index doesn't seem so bad.

It's also possible you could find an index that isn't capitalization weighted. However this can have many pitfalls as well. The DJIA for example is not capitalization weighted. It is based on one share of stock in each of the 30 companies divided by the DJIA divisor. So in this case a huge company like MSFT with a stock price of 25 has 1/5 the impact of a large but smaller company like IBM with a 130 dollar stock price. Is that really what you want?

I think if you take a weighted index fund in large mid and small stocks and put 1/3 of your money in each you have effectively eliminated the large cap problem you are discussing.

If you don't think so I would be interested to know why you think that doesn't solve the problem?

[MBTN]

One other twist is that when you actually find a "better than average" money manager, the money starts to flow into the fund. When this happens it becomes harder and harder for the manager to keep finding ways to invest the money. Also, the spotlight puts pressure on the money manager to not get beat by the market, so there is some incentive to just become a defacto index fund.

[BillV]

Brad,
You can do what Apex suggests and if you really want to diversify,, you can further split your funds by growth and value funds. That is to be clear, large growth/large value, mid cap growth/ midcap value and the same with small.