Morningstar: Fees a slightly better predictor of mutual fund success than its star rankings

Fund investors: Consider fees first, then stars

BOSTON — A new study reinforces time-tested advice for investors shopping for mutual funds: Look first for funds with low fees, then go from there.

Fund expenses are a slightly more important factor in predicting how well a fund will perform than the one- to five-star system that Morningstar Inc. uses to rate funds, the company said in a study it published Monday.

Comparisons of fund fees and star ratings “have demonstrated they’re both useful tools for getting the odds in your favor, and they’re very good starting points for investors,” said John Rekenthaler, who helped produce the study and is vice president of research at Chicago-based Morningstar.

The star ratings, which date to Morningstar’s founding in 1984, are widely used to sort the good funds from the bad, and many fund companies run ads touting their funds’ five-star ratings. Other research firms provide less commonly used ratings that follow different methodology.

Morningstar’s star system measures a fund’s past performance while also weighing how much risk a fund took to achieve its returns. For example, a fund that produced far-better-than-average results over 10 years won’t necessarily secure a top rating if its performance was unusually volatile during that period.

The star ratings “are a summary of what has occurred in the past, and an introduction to a fund,” Rekenthaler said.

Funds charging lower fees than most of their peers are far more likely to get higher star ratings from Morningstar than pricier ones, Rekenthaler noted.

In 58 percent of the instances Morningstar studied, expenses were a better predictor of success than a fund’s star rating. Expenses were a bigger factor in 23 of 40 cases comparing data starting in 2005 and ending in March 2010.

Morningstar defined a fund’s success as the ability to outperform similar funds in the same investment category, and also survive during the period studied, rather than being shut down by the fund company.

That’s important because performance comparisons can be skewed if they leave out funds that cease operations, often because they didn’t perform well.

The easiest way to compare fees is to consider a fund’s expense ratio — the ongoing charges that investors pay, expressed as a percentage of assets — against the expenses that similar funds charge. For example, expenses at an emerging markets stock fund are likely to be higher than those of a Standard & Poor’s 500 index fund.

The study concluded that investors should make expense ratios a primary test in fund selection, because they are still the most dependable predictor of performance.

The research expands on other independent studies that have underscored the importance of considering expenses, which are a definite and easily measured drag on future returns. The reality is that few funds can sustain periods of strong performance for more than a couple years, as fickle markets change direction and the fund reverts to being an also-ran.

Morningstar’s study didn’t consider factors that it believes are less important in predicting fund returns than expenses and star ratings. Those include a fund manager’s tenure, or whether the fund tends to trade stocks or bonds frequently, rather than practicing a buy-and-hold approach.

To highlight the differences, Morningstar examined only funds that had unusually high or low expenses, and those with either one-star or five-star rankings. Funds with middle-of-the-road expenses were excluded, as were funds earning two, three, or four stars. The research examined funds investing in various categories of stocks as well as bonds.

In some instances, the differences were big. For example, U.S. stock funds charging the lowest fees posted an average annual return of 3.35 percent from 2005 through March 2010. Those charging the highest fees averaged 2.02 percent. The difference between those two numbers — 1.33 — is higher than many charge in expenses alone.