Fees: the proven predictor of unit trust returns

Anyone investing in unit trusts in South Africa is faced with a daunting choice. There are now over 1 300 funds registered in the country.

Even if you only look at the two most populated fund categories – South Africa equity general and South Africa multi asset high equity – there are 211 and 186 funds respectively. Choosing an appropriate fund out of this universe is no simple task.

The way most investors tackle this problem is to select the funds that have been the recent top performers. However, there is often little understanding of what has been behind this performance or what factors will determine whether or not it continues.

And as every fund fact sheet has to reiterate, past performance is no guarantee of future returns. Short-term performance especially can be very misleading.

Fund research house Morningstar therefore believes that while past performance shouldn’t be ignored, it is not the most reliable predictor of what to expect in the future. What is however a pretty good indicator is the fees that funds charge.

Analysis released by Morningstar on Monday re-confirms something that the company has shown before – that funds with lower charges are more likely to out-perform in future. And those with higher charges are not only more likely to under-perform, but to shut down altogether.

“The expense ratio is the most proven predictor of future fund returns,” the report states. “That’s not to say investors should use them in isolation. There are many other things to consider, but investors should make expense ratios their first or second screen.”

The proof in this statement lies in an analysis conducted across all funds in the US. It looked at the percentage of funds that both survived and out-performed their category group – which it called the ‘success ratio’ – and compared this to the fees they charged.

“To begin any test of predictive power, we use historical data so that we are using the data that investors would have had access to at the time,” Morningstar explains. “That includes funds that no longer exist. In fact, that’s a key part of the story because higher-cost funds are much more likely to fail and be merged away.”

The analysis ranked all the fund categories into quintiles based on their expense ratios at the start of the time period under review. And what the analysis found was that, without exception, the least expensive funds were most likely to be successful.

“We’ve done this over many years and many fund types, and expense ratios consistently show predictive power,” the report states. “Using expense ratios to choose funds helped in every asset class and in every quintile from 2010 to 2015.”

For example, funds in the cheapest quintile in the US equity category showed a total return success rate of 62%. The most expensive quintile delivered a total return success rate of just 20%.

As the chart below shows, there is a consistent correlation between costs and performance across every fund category.

Source: Morningstar, Data as of 12-31-2015.

“While we think it makes sense to consider a variety of factors when choosing funds, our research continues to find that fund fees are a strong and dependable predictor of future success,” says the study’s author, Russel Kinnel. “We found that the cheapest funds were at least two to three times more likely to succeed than the priciest funds. Strikingly, our finding held across virtually every asset class and time period we examined, which clearly indicates that investors should keep cost in mind no matter what type of fund they are considering.”

The full report can be downloaded here.

Brought to you by Moneyweb