Mutual Funds - Fees Matter. New Study from Vanguard

Although Vanguard promotes low cost mutual funds, their data is consistent with a 2011 Morningstar study and many other studies that have been done over the years. Bottom line: fees may be the best predictor of long term mutual fund performance. FYI:  1. alpha is the amount a mutual fund outperforms the market.          2. survivorship bias-some studies remove closed mutual funds

Probability of remaining in top-performing fund quartile: Holding periods of 1, 3, 5, and 10 years (1990 through 2010) Too often, investors view a fund's historical performance as the most accurate predictor of its future success. But Vanguard has found that more than any other quantifiable attribute that we examined, lower costs are associated with higher risk-adjusted returns. The figure below shows the probability that an actively managed mutual fund in the top-performing quartile would remain among the highest-alpha funds in subsequent 1-, 3-, 5-, and 10-year periods. The outcome was no better than would be expected from a random selection of funds and was sometimes worse. Notes: Each fund was evaluated relative to its customized benchmark using the Fama-French-Carhart expanded market model (Fama and French, Journal of Financial Economics 33:3-56, 1993; Carhart, Journal of Finance 52:57-82, 1997). Sources: Vanguard calculations, using data from Morningstar, Inc. Data exclude sector funds, real estate funds, and specialty funds such as bear-market funds. Outperformance of U.S. equity mutual funds by expense-ratio quartiles: 5, 10, 15, and 20 years ended December 31, 2010 Our research shows that a fund's expense ratio is a more powerful predictor of relative performance than other readily observable fund characteristics. On average, for every 1 percentage point increase in expenses, alpha declined by 0.78 percentage point. The second most powerful variable was portfolio turnover.1 For every 1 percentage point increase in portfolio turnover, alpha declined by 0.22 percentage point. In the figure below, actively managed funds that outperformed their relevant style indexes over the 5, 10, 15, and 20 years ended December 31, 2010, are grouped by cost quartile. Over the 20-year period, 49% of the funds in the lowest-cost quartile beat the benchmark while a mere 16% of funds in the highest-cost quartile did so. Similar patterns were apparent in shorter time periods. Since selecting active managers that consistently outperform their respective benchmarks is such a difficult task, focusing on low-cost index funds is a helpful and valuable quantitative measure. 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.