Past Performance or Fees

I’ll keep saying it until everyone gets it, or until my dying day (I’ll bet on the latter happening first); investing is too simple to be this complicated!

Take the process of picking a mutual fund, for example, many investors agonize through the process of fund research. They seek out the “hot hands” — hoping to find a winning manager. Even though every fund prospectus states that, “...past performance does not guarantee future results,” investors still believe that a track record means something.

The preeminent mutual fund resource, Morningstar, tries to help investors sort through the confusing array of past performance parameters by crunching numbers to create its “star” ranking. Basically, a five-star fund has had the best history with one-star funds posting pitiful past performance. It’s a rare mutual fund manager that doesn’t crow after receiving the coveted Morningstar five-star rating. So, given the time and money investing in rating funds based on their historical behavior, you would think that Morningstar would believe that their rating is the best way to choose a fund for the future.

In 2010, Morningstar decided to put their system to the test. What the found surprised everyone (even though it shouldn’t have): Neither past performance nor Morningstar’s ratings were particularly good indicators of future results. Over and over again, one single factor seemed to, almost uncannily (sarcasm intended), predict better future returns, expenses.

Go figure. Pay less, make more. It seems too easy. Does this mean that all of those expensive researchers, analysts, and managers don’t provide value? The answer appears to be, yes. It turns out that paying someone a whole bunch of money doesn’t make them any better at predicting the otherwise unknown future.

Expensive mutual fund companies (and possibly even a few number crunchers at Morningstar) weren’t happy. They tried to make a case for expensive active management.

In 2013, the CEO of an actively managed fund group, U.S. Global Equities told the Wall Street Journal, “I believe a portion of an investor's diversified portfolio should hold actively managed funds, especially for specialized equity markets that require specialized knowledge and expertise, as the pricing tends to be inefficient. These areas include emerging markets, small-cap stocks and companies involved in resources and metals mining. The key is in selecting an active manager who has extensive experience investing in these markets, as they understand the seasonal and historical patterns that help them navigate these complex areas.”

Later in the same article, investment advisor Rick Ferri responded with the results of a Vanguard study that showed, “...a significant majority of actively managed funds in so-called inefficient sectors such small-cap stocks and emerging markets have not delivered on the promise of outperformance.”

Read WSJ Article (subscription may be required)

Apparently, there aren’t many good arguments for the higher fees charged by active fund managers. Yet, the majority of fund investors still put their money in pricey active funds. Do they know something we don’t? What will Morningstar’s next study show? Can we go back to picking pricey five-star funds?

The wait is over. Morningstar has sorted through the data, and the 2014 results mirror those of 2011. Low fees are the best indicator of future results. So, it has to be official now: All else being equal, if you pay less and you should make more. So, why are you still investing in expensive, actively managed funds?

Read Morningstar Report