Expense ratio is key determinant to returns


This entry includes highlights from a journal in CFA publications. My intention is to urge investors to invest in low cost index funds. The general rule of thumb is, the higher the cost, the lower your rate of return. Active managers who can outperform the market is incredibly hard to find. In fact, it’s quite improbably to find one who can outperform the market persistently, net of fees, over a long time.
There is extensive, undeniable data which show that identifying in advance any particular investment manager who will—after costs, taxes, and fees—achieve the holy grail of beating the market is highly improbable.
If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.
[Kinnel, Russel. 2010. Morningstar FundInvestor, vol. 18, no. 12 (August):1–3.]
Whether one is investing a lump-sum amount or a series of periodic amounts, the arithmetic of investment expenses is compelling. Although a long-term investor may be able to find one or more high-cost managers who can beat an appropriate benchmark by an amount sufficient to more than offset the added costs, the reality is that “compared with the readily available passive alternative, fees for active management are astonishingly high” (Ellis 2012, p. 4).
Managers with extraordinary skills may exist, but as I argued in this publication many years ago (Sharpe 1991), another exercise in arithmetic indicates that such managers are in the minority. And as Ellis has reminded us, they are very hard indeed to identify in advance.
References
Ellis, Charles D. (2012). “Investment Management Fees Are (Much) Higher Than You Think.” Financial Analysts Journal, Vol. 68, No. 3 (May/June): 4-6.
Kimmel, Russell (2010). Morningstar Fund Investor, Vol. 18, No. 12 (August): 1-3.
Sharpe, William F. (1991). “The Arithmetic of Active Management.” Financial Analysts Journal, Vol. 47, No. 1 (January/February): 7-9.
Vanguard Group (2012). “Vanguard Total Stock Market Index Fund Admiral Shares.”
https://personal.vanguard.com/us/funds/snapshot?FundId=0585&FundIntExt=INT#hist=tab%3A3 (accessed 5 July 2012)