The smartest kid in your 4th grade class was probably the smartest kid in your 5th grade class as well. The best quarterback in the NFL this year is likely to be one of the best next year. The company’s top salesperson from this year will probably be near the top next year.
You get the idea–in general, top performers continue to be top performers.
Mutual funds work the same way, right?
It’s certainly understandable that many investors expect the same sort of thing to hold true when selecting fund managers. It’s reasonable to think that if a guy has done well at his job before, he will probably continue to do well. That’s just common sense.
Too bad it doesn’t work.
Financial Research Corporation released a study several years ago entitled “Predicting Mutual Fund Performance II.” While I haven’t personally read the study–it costs $2,500 to purchase a pdf copy–multiple trustworthy sources have shared the study’s most important takeaway:
Among mutual funds in a given asset class, expense ratios are the only statistically reliable predictor of future performance.
Read that again. It’s not just saying that expense ratios are the best predictor, it’s saying that they’re the only reliable predictor.
The study showed that the typical methods for predicting performance (examining past performance or manager tenure, for instance) are not significantly more successful than guessing randomly.
Applying this to your investments
There’s no question about the conclusion to be drawn from this study: Low-cost index funds (or lower cost ETFs) are your best bet for every single part of your portfolio.
In other words (and to use a real-life example) given the choice between the following two funds (assuming they’re in the same asset class):
- Fund A: 5.82% avg. annual return over last 10 years, 1.12% expense ratio
- Fund B: -2.11% avg. annual return over last 10 years, 0.09% expense ratio
…I’ll choose Fund B every time.
Want to learn more about investing?
Enter your email address to receive free updates from this blog. (You won't receive any emails other than blog posts, and you can unsubscribe at any time.)Like Cliffs Notes...for Investing
| If you're looking for a brief, plain-English introduction to investing, I'd encourage you to pick up a copy of my book: Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less. |  |
{ 8 comments… read them below or add one }
OI – I mentioned this phenomenon in my most recent blog post, and recalled how Benjamin Graham and Jason Zweig talked about this in The Intelligent Investor. That concept and some of the ideas you talk about here (I linked you) helped my shape my strategy going forward in regards to my 403b. I had a half dozen different funds which undoubtedly ate up a bit of my earnings with all of their maintenance fees.
I’d want to know why fund B underperformed. If manager simply not qualified to run a fund, that would eliminate it from consideration.
But otherwise, I agree that going forward, the chances of making money this year are better with fund B.
2500 to read a pdf o.O!?
I agree if you have a choice of funds pick the less costly- as you get what you don’t pay for… It’s easy when just comparing two like funds but what do you do when assessing the entire portfolio?
For instance I have a 401K account with very limited investment choices. There is only one index fund available. It is very low cost S&P 500 (0.09%), but I don’t like the idea of limiting myself to only US large cap stocks. The other funds are actively managed with no load and total fees ranging from 0.3% – 1.25%, but they cover other asset types (REITs, bonds, small cap US stocks, foreign stocks, etc.)
I think diversification is worth paying some additional frees but what I would really like to know is at fee % would the advantage of diversification be lost to the additional fees?
-Rick Francis
Hi Rick.
That’s a tricky situation–though one in which many investors find themselves. Do you have a significant amount in an IRA? If so, depending upon its size relative to your 401k, it might make sense to allocate the entire 401k–or at least a large portion of it–to the S&P fund, then adjust your non-401k allocation accordingly.
I could agree that low fees are the only factor that can be easily examined in a study that would work. I don’t agree that low fees are the only factor that can work.
It is true that most mutual fund managers do not pick stocks effectively. Most are trying to attract investors to their funds. The way to attract investors is to pick stocks that most investors see as good picks. Marketing considerations push fund managers in a direction contrary to the direction in which their stock-picking skills would push them if they were indeed effective stock pickers.
I would look for fund managers who demonstrate an independent intelligence and a long-term focus. That’s what works with stock picking.
There aren’t many fund managers out there who have this. It takes time to find them. And there is no real need to put in the effort — you can do fine investing in index funds. Still, I think it is an overstatement to say that there are no funds other than index funds worth investing in.
Rob
Mike,
I do have Roth IRAs for my wife and myself- but it would not be enough to give me my desired allocation % if the 401K was completely S&P500. I can get fairly close for now however, the problem will get worse over time for a few reasons: The contribution maximum for the 401K is larger than the Roth IRAs. I will be allocating more into bonds as I get older. Finally from a tax point of view it seems to make more sense to put stocks in the Roth accounts to maximize the growth and bonds in the 401K.
Even if I had complete freedom to choose any funds- the fees still vary somewhat on different index funds. For example VTI (Vanguard Total Stock Market ETF )’s management fee is 0.09% while VT (Vanguard Total World Stock ETF ) is 0.3%. Is that added diversification worth the extra cost?
I think it is an answerable question- just subtract the compound annual growth rates over long period of time for the S&P500 and for a diversified portfolio the difference is the value of that diversification. I’ve seen data for the S&P500, but not for diversified portfolios.
-Rick Francis
Hmm…that is indeed tricky. The points you make about it getting worse over time due to differences in contribution limits and an increasing bond allocation make sense to me.
To me, the cost difference between a Vanguard international stock ETF and a Vanguard domestic stock ETF is small enough that it’s absolutely worth diversifying. (Roughly 30% of our equities are international at the moment, and ongoing contributions are weighted more heavily in that direction.)
However, the cost difference between a (very low cost) S&P index and an actively-managed international fund is probably much more substantial.
I think my approach would be, after putting the most in the S&P fund that you feel is reasonable, to see which of the other asset classes has the lowest cost fund available in your 401k. (That is, after the S&P, is the fund with the most reasonable ER an international equity fund, or is it a bond fund?) Allocate as much as you feel is reasonable into that fund, and adjust your Roths accordingly.