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My Two Cents

The High-Cost of High-Fee Mutual Fund Flops

Chris Farrell May 4, 2007

High-cost mutual funds are hazardous to your returns. If everything is equal low-cost funds will outperform high-cost funds simply because of the former’s cost advantage. “However, all things aren’t equal amd most high-cost funds also have weaker management, higher risk strategies, and fewer resources,” writes Russel Kinnel, director of fund research at Morningstar.

Kinnel notes that high-cost funds are far more likely to disappear than their low-cost peers. He examines the survivorship rate of low-cost and high-cost funds, and any gap in survivorship rate should give an investor a good feel for the odds of success when picking a fund.

Kinnel found that you can double or triple the odds of success by being a cheapskate. Take tech funds. All the tech funds that existed in 1998 that were in the cheapest quintile of their category were around 5 years later when the tech market rebounded. In sharp contrast, 47% of the priciest tech funds were liquidated or merged away before the upturn

Let’s look at his data on domestic stock funds. The quintile with the lowest expense ratio had an attrition rate of 13% over five year periods, and 25% over 10 year time frames. Yet 29% of the high cost funds had been liquidated or merged over 5 year periods and nearly half over 10 year periods.

How about returns? First, he separates the funds into quintiles based on cost and then sees what percentage within each group beat the category average. Of domestic stock funds, 47% in the cheapest quintile succeeded over a 10 year period in beating the category average. For the next cheapest quintile the comparable figure was 33%, then 30% for the middle group, 27% of the next quintile, and a mere 19% of the most expensive quintile.

Bottom line: Fees matter a lot when evaluating a fund. Don’t buy the rhetoric that more expensive means better. It doesn’t, at least on Wall Street.

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