Cheap Wins Every Time

Yet nearly every day, I hear from a reader who says really talented managers are worth the money.

I've developed an admiration for Jack Bogle's thoroughness. The founder of the Vanguard funds will explain nine ways to Sunday why it's important to consider costs when you select a fund. He'll make his case first from one perspective, then he'll take another angle that leads to the same conclusion. After that, he'll put the naysayers' point of view to the test and show that their arguments don't hold up.

Powerful predictors. Over the years, I've run tests in many different ways and found the same thing that Bogle and the academics have reported: Mutual fund expense ratios are powerful predictors of performance. Yet nearly every day, I hear from a Morningstar FundInvestor reader who says, "Yeah, costs matter, but ..." Some say that really talented managers are worth the extra money. Others say that you shouldn't care what a fund's expenses are as long as the returns are great. And others point to a high-cost fund that managed to produce great returns. But I've considered all that. I've found that in general, funds with strong past performance and high costs won't do as well as funds with poor past performance and low costs. No wonder Bogle explains it from so many angles.

When you find a strong-performing fund run by an articulate manager, happy little bells go off in your head that tell you that you have found The One. The manager is a Master of the Universe, and a pedestrian 0.75 percentage point disadvantage is not going to trouble him. Why, if he just matches what he's done in the past five years, you'll retire early and buy that awesome BMW you've had your eye on. It's tough to persuade someone that Bogle's "humble arithmetic" is more powerful than that.

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I recently ran a comparison that makes the cost-data case particularly compelling: I factored in funds that are no longer alive and kicking. High-cost funds are much more likely to fail and be liquidated than low-cost funds. That means many expense studies (and investors' memories) tend to understate just how poorly high-cost funds do.

You can't attach a precise total-return number to extinct funds, but I got around that problem by looking at it from the point of view of success. I define a successful fund as one that survived and did better than its peers. Based on that standard, you see a sharp drop-off just going from the first quintile of low-expense-ratio funds to the second quintile. The attrition rate soars from 10% to 35%, and the success rate plummets from 50% to 32%. Moving all the way up to the priciest quintile, the success rate falls to 20% and the attrition rate pops to 50%. Put another way, the funds in the cheapest quintile are two and a half times more likely to succeed than funds in the priciest.

As important as costs are, you still want to examine other fundamental criteria. A fund should have strong management, good stewardship, a sound investment strategy and even a good long-term track record. Some of my favorite actively managed cheap funds are Dodge & Cox Stock (symbol DODGX), Vanguard PrimeCap Core (VPCCX), T. Rowe Price Equity Income (PRFDX) and Vanguard International Value (VTRIX). Each has great management, low turnover and an expense ratio of less than 0.7% of assets. That means these smart managers need to add only about a half-percentage point of value to catch up with index funds.

Index alternatives. You can drive down your costs if you are as careful choosing index funds as I was in selecting the actively managed funds above. My picks would be Fidelity Spartan Total Market Index (FSTMX), Vanguard Tax-Managed Capital Appreciation (VMCAX), Vanguard Intermediate-Term Bond Index (VBIIX) and Fidelity Spartan International Index (FSIIX). The two Fidelity funds charge just 0.10% and are the cheapest options if you invest between $10,000 and $100,000. Above and below that band, Vanguard has the cheapest choices.

Columnist Russel Kinnel is director of mutual fund research for Morningstar and editor of its monthly FundInvestor newsletter.

Russel Kinnel
Contributing Editor, Kiplinger's Personal Finance