04 Jul Why low-cost investing beat high cost
One of our core investing principles is to keep costs within the TRAILS™ portfolios as low as possible.
Costs reduce an investor’s net return and represent a hurdle for a fund. Before a fund can outperform, it must first add enough value to cover its costs. As leading economist Gene Fama once observed that, “money is like soap, the more you touch it the smaller it gets.”
All mutual funds incur costs. The question is not whether investors must bear some costs, but whether the costs are reasonable and indicative of the value added by a fund manager’s decisions.
Data shows that many mutual funds are expensive to own and don’t offer more value for the higher costs incurred. Research by Morningstar1 shows that fund expense ratio is the most proven predictor of future fund returns. That’s also what academics, fund companies and of course, Jack Bogle (founder of Vanguard) find when they run the data.
Russel Kinnel, the author of the report, concluded that ‘If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratio helps you make a better decision. In every single time, period and data point tested, low-cost funds beat high-cost funds. Expense ratios are strong predictors of performance. In every asset class over every period, the cheapest quintile produced higher total returns than the most expensive quintile. Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you’ll be on the path to success.’
The data behind this research is updated every year, and the findings remain consistent. In the latest research, Morningstar put the fund in 5 categories (known as quintiles) based on their expense ratios. Using expense ratios to choose funds helped in every asset class and in every quintile from 2010 to 2015. For example, in U.S. equity funds, the cheapest quintile had a total-return success rate of 62% compared with 48% for the second-cheapest quintile, then 39% for the middle quintile, 30% for the second-priciest quintile, and 20% for the priciest quintile. So, your chances are better, the cheaper the quintile. All told, cheapest-quintile funds were three times more likely to succeed than the priciest quintile!
Russel Kinnel (2010) How Expense Ratios and Star Ratings Predict Success
Available at Morningstar
Perhaps no surprise then, when constructing our TRAILS™ portfolios, our approach is to select low-cost funds among other criterion. Charges taken by the fund manager can impact substantially on the fund returns, especially in flatter markets. Costs, like interest, also have a compounding effect over time.
The typical ongoing cost of a TRAILS™ portfolio is just 0.30% per annum. This means that our clients have a greater chance of achieving their desired returns. You won’t be paying large fees to investment managers at Tandem, most of whom don’t beat the index anyway!
There are 11 TRAILS™ funds and this is the maximum in any of 7 portfolios from Defensive to Speculative. The annual management charges (AMC) range from 0.15% to 0.75% but the weighted average AMC is 0.26% with the weighted average annual on-going charges figures (OCF) being 0.30%.