Expense Ratio Does Not Necessarily Predict Future Performance

May 3, 2004 (PLANSPONSOR.com) - Using a single factor to select mutual funds may not be the best method, especially if that factor is expense ratios.

Investors that rely on expense ratios alone to try and predict the future performance of a fund are only getting part of the picture, Lipper found in the firm’s “How Well Do Expenses And Net Returns Predict Future Performance?” report.   Rather, investors should use a group of tools or ranking mechanisms to reduce the vast universe of U.S. mutual funds to a handful of candidates from which to make a choice.  Overall Lipper finds single-factor models utilized to select investments in most cases have a drawback.  

In fact, Lipper found that only inno-load and institutional funds does the buying of the least expensive funds improve an investor’s odds of “picking an index-beating fund.”   Across all other fund types higher expense ratios tend to be associated with higher returns for load shares.   Broken down, Lipper found that in only three of the eight equity share classes does picking low-expense funds improve the odds of selecting index-beating funds – defined as a fund that outperformed its respective Lipper index over a three-year period.   Similarly, for bond funds the selections of low-expense funds improve chances of besting the Lipper index in only three out of nine share classes.

Further, Lipper examined the characteristics of index-beating funds and found the level of management fees to be a primary explainer of performance and nonmanagement expenses and the presence – or absence – of 12b-1 fees a significant secondary descriptor.   Overall, Lipper finds 12b-1 fees are a “dead-weight cost” in no-load funds that investors accept “because they know very little about it and less about how to evaluate its economic impact.”   By comparison, in load-bearing shares, Lipper finds some grounds for the dead-weight cost argument, but the cost ” is mitigated to some extent by the possibility that 12b-1 fees help counteract redemptions with new sales in order to avoid selling into market weakness and, more importantly for load shares, that brokers and planners are counseling investors not to sell and thereby incur a service fee after poor performance periods.”

A copy of the report is available on Lipper’s Research Studies Overview page found  here .