Morningstar released a study demonstrating that expense-ratios are one of the best predictors of future mutual fund performance. Their analysis was done across fund categories within a 5 year time span, and consistently demonstrated that low-cost funds beat out high-cost ones.
Although the Morningstar rating system accurately predicted fund performance 84% of the time, funds’ expense ratio was a better predictor than their star-rating system by 58%. The main detriment of Morningstar is that its rating system only measures past performance, and the time sensitivity of the ratings make them less effective when there are swings in the market. This is due to the fact that regardless of market conditions, the same operating and management costs are charged. Given a higher return, a higher expense ratio can be justified. But with poorer returns, a high expense ratio will significantly eat into your investment. In general, a low expense ratio is an excellent predictor of fund performance because you are spending less on administrative costs, and as a consequence, have greater fund earnings distributed back to you.
What this and other studies continually show is that we can’t predict the returns of a fund by looking how it previously performed—as a specific fund was managed and aligned with past market conditions. What’s more, you should always look at a fund’s expense ratio, and generally seek out funds with lower expense ratios. While there are no guarantees, there are ways to dramatically safeguard your savings and grow your investments. Looking at a fund’s expense ratio is one way of doing this.