We studied the predictive power of expense ratios, the Morningstar Rating for funds, Morningstar Investor Returns, something I call manager returns, and active share. Too often, studies on predictive power fail to account for fund destruction even though more than half of the funds get merged away or liquidated less than 10 years after their creation. Often those funds aren't eliminated because things are going great.
Key to our analysis is a test of success ratios that shows what the chances are that a given measure will lead to funds that survive and outperform their peers. Thus, even the failures that are merged away are counted.
You may recall that last year I shared some results of a study on how the star rating and expense ratio fared at predicting future success. Specifically, I asked what the chances are that a certain group would survive and outperform--the success ratio. The results were pretty encouraging for both. Investors improved their chances of success if they used either star ratings or expenses as part of their process.
I was surprised that some people interpreted that study to mean either the star rating was useless or that actively managed funds were. My guess is that many didn't actually read the study. In fact, the data suggest that the star rating is very helpful. And that study doesn't speak to the success of active versus passive funds. That expense ratios were somewhat more valuable than star ratings hardly invalidated the star rating. If you told me antilock brakes were more valuable than air bags, I'd still want them both. On the second point, the study did not prove that indexing is superior in all circumstances.
Here, I'll focus on how the five measures fared at predicting the success ratio over the ensuing five-year period. We grouped funds into quintiles within category based on data ended Dec. 31, 2005, and then tallied up their performance and survival rates over the next five years. (Note that this is a slightly more recent time period than previously published studies of the subject.)
The data reveal that all five data points tested were at least slightly helpful, but three of them particularly can help investors make better decisions. The star rating, expense ratios, and manager records all helped investors do much better than the average fund over the time period we examined. Yet none consistently led to the best results, and, in combination, two did even better than any single factor.
Screening for funds that were rated 5 stars and in the cheapest quintile of their category yielded a high chance of success. While some have advocated a myopic focus on one data point, the data suggest that more is better, provided you use the right data points.
So, how much do they help? Let's look at how much they improved an investor's chances of success:
A domestic-stock fund rated 5 stars was 30% more likely to succeed than average and 2.2 times more likely to succeed than a 1-star fund. A cheapest-quintile domestic-stock fund was 46% more likely to succeed than an average-expense fund and 2.2 times more likely than one from the costliest quintile. A fund with a superior manager record was 43% more likely to succeed than one with a middling record and 1.9 times more likely than one with a bottom-quintile record. A fund with top-quintile investor returns was 15% more likely to produce success than a middle-quintile fund and 1.6 times more likely than the bottom quintile for investor returns. A fund in the highest quintile for active share was 10% more likely to succeed than the middle quintile for active share and 10% more likely than the bottom quintile.
However, topping them all were the cheap 5-star funds, which were 57% more likely to succeed than a fund with an average star rating or an average expense ratio and 2.6 times more likely to succeed than a 1-star or high-cost fund.Background
The star rating is a quantitative measure of load- and risk-adjusted performance. It's based on a fund's trailing three-, five-, and 10-year performance, and it is relative to the category so that each category has a bell-curve distribution of star ratings. There are as many 1-star funds as 5-star.
Expense ratios reflect a fund's fees for management, servicing, and distribution. The fee is spread out over the course of a year so that a bit is charged to shareholders each trading day. The expense ratio does not include stock commissions or front loads.
Morningstar Investor Returns are an asset-weighted measure of past performance that helps explain whether investors are using a fund well. When we came up with the concept, we thought of it as more of a measure of how well investors could handle a fund's ups and downs rather than a predictor of returns, but I wanted to put it to the test for both success ratios and investor returns. I grouped funds into quintiles based on their trailing five-year investor returns within a category for the period ended 2005.