Mutual Fund Study Debunks Criteria

A Lipper study says fee ratios and past performance aren't likely to help you pick future winners.
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When a fund company writes in its prospectus, "past performance cannot guarantee future results," it is not just covering the legal bases. Chances are, it really means it.

In a study out Monday, Lipper analyst Andrew Clark contends past performance and fund costs -- the two items usually found atop any investor check list for choosing a mutual fund -- are not as helpful in picking future winners as is widely believed.

Clark's study ("How Well Do Expenses and Net Returns Predict Future Performance?") found that for both open-end equity funds and taxable bond funds "there is often no difference between using low expenses versus good three-year returns for picking index-beating funds."

The study also says that shopping for low-expense funds won't necessarily improve your chances of picking an index-beating fund. According to Clark, sometimes choosing funds with the highest expenses will help you beat the index more handily than bargain shopping based on fund fees.

And Clark says the same counterintuitive way of thinking often applies to fund investors who use a fund's trailing three-year returns (a popular industry measure) to make their fund buying decisions. "The funds with the lowest three-year returns in the prior period will, in some share classes and load types, net you the most index-beating funds in the next three-year period."

The Lipper study looked at 49 classifications of funds -- 31 open-end equity funds and 18 taxable bond funds -- over a period of 12 years (1992-2003), as well as eight equity share classes and nine bond share classes.

A single mutual fund, with one portfolio of stocks and one investment adviser, may offer more than one class of its shares to investors. Each class represents a similar interest in the mutual fund's portfolio. The principal difference between the classes is that the mutual fund will charge you different fees (loads) and expenses depending upon the class you choose.

Clark's inclusion of different share classes differentiated the Lipper study from other such analyses, which usually stick with a single class of shares. It also led him to the conventional wisdom-defying conclusion that funds with "higher expense ratios tend to be associated with higher returns for load shares."

In the case of no-load shares, Clark's study found the conventional wisdom held true; that lower expense ratios tend to be associated with higher returns.

When it comes to the controversial 12b-1 fees -- a type of mutual fund fee charged annually on some funds to cover promotional and distribution costs -- Clark makes a distinction as to their effect on no-load shares and on load shares. For no-load shares, the study concluded that the fee is "primarily a dead weight cost that investors accept because they know very little about it and less about how to evaluate its economic impact."

For load shares, Clark thinks there is a possibility that the fees help counteract redemptions because brokers and planners have a history of counseling investors to hold onto their funds after a poor performance period instead of simply absorbing the sometimes significant cost of the service fee.

Critics of the Lipper study say the three-year testing period is far too short to make such conclusions on the relationship between fees and returns.

"The expense advantage compounds over time," says Morningstar analyst Russ Kinnel. "Three years is not enough. If you run the study out to 10 years, you will see that expenses are the strongest predictor in a category by far."