The old adage in the journalism business is that "dog bites man" is not news, but "man bites dog" IS news.
I thought of this recently when fund-research giant Morningstar – originator of the ubiquitous "star rating" system for mutual funds – published a study in which it found that fund expenses were actually a better predictor of future performance than were star ratings. Specifically, the study found a much stronger link between funds that had low expense ratios and high future performance than it did between funds with high star ratings and high future performance.
To those of us at Capital Directions, this information is of the “dog bites man” variety. We have been trumpeting this point for more than 15 years now, often, it seemed, to deaf ears. What made this a “man bites dog” event is that the information came from Morningstar itself, the very firm that has made much of its living from touting the virtues of its star-rating system. It was as if the Wizard of Oz pulled his own curtain back.
Not surprisingly, the study garnered a huge amount of attention in the press (perhaps more than Morningstar bargained for), and no wonder: The notion that Morningstar would assert that fund fees would trump star ratings in doing fund research was something of a shocker.
Yet that’s exactly what they said. According to Russel Kinnel of Morningstar, who authored the study, “If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”
In an effort to protect the franchise, Morningstar then went on to assert that high-star funds tend to outperform low-star funds, but admitted the link wasn’t nearly as strong as the fee connection.
The implications for those in the industry who use star ratings to sell past performance to prospective clients are thus clear: As far as predicting future performance goes, you are far better off looking for low-fee funds than high-star funds. The very group that compiles the rankings says so themselves.
Alas, this presents a problem for all those brokerage firms, banks and insurance companies out there who love to sell the star ratings, because their fund fees are often…let me see if I can find the right word…unconscionable. Many times these providers’ funds have expense ratios well north of 2%, and high turnover ratios that bring total annual fund costs into the 3% to 4% range.
When you have a fund family that consists of dozens or even hundreds of funds, as most of the large financial services firms do, then it’s easy to back into some high star ratings. If you have enough players in the game, you’re going to hit some home runs just by virtue of having a lot of different at bats. So every few months, these providers cull their top performers and roll out the marketing machine to tout what amazing star ratings these funds du jour have received.
But if you force these firms to start touting their low expense ratios instead, then…gulp. Not what you would call a lot of fodder for an ad campaign there. Suffice it to say, then, that these firms are hoping the Morningstar study fades quickly from the investing public’s memory.
Don’t let it fade from yours the next time a broker hands you a list of five-star funds and begins to tout their virtues. Likewise if you are a trustee of a retirement plan and the provider’s “recommended fund list” is heavily weighted toward star ratings. Ask them to show you a list of their lowest fee funds instead and see what their reaction is.
If big beads of sweat appear on their foreheads, then you know you are talking to the wrong people…
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