Want high fund returns? Cut your costs

Mutual fund investors can improve their returns by focusing on the costs of running individual funds, says former Vanguard Investments Chairman John C. Bogle. “Costs clearly differentiate the superior performers from the inferior performers,” he writes. Bogle showed that costs matter in his newest book, “The Battle for the Soul of Capitalism” (Yale University Press, 2006).

He did a study of the gross and net returns of 942 funds that invested in U.S.stocks for the 10 years ended in February 2005. The average cost of running the funds was 1.9%, a rate that included 1.2% in operating expenses and estimated portfolio transaction costs of 0.7%. Bogle found that the one-quarter of funds with the highest costs, averaging 3%, returned 9% a year on average to investors. However, the one-quarter of funds with the lowest cost, with expenses of just 0.9%, returned 11.7% on average to investors. “The low-cost funds enjoyed a premium of 30% per year in annual return over the high-cost funds, confirming the thesis that the higher the cost, the lower the total return,” he wrote.

His study found that the highest-cost funds also assumed the most average risk. “The high-cost quartile carried a risk that was an amazing 34% higher than the risk carried by the lowest-cost quartile,” he wrote. In addition, the high-cost funds had much higher turnover in their portfolios than did the low-cost funds, some 152% turnover per year vs. just 19% for the low-cost competitors. This gave the low-cost investors an even bigger advantage in risk-adjusted returns, he wrote.

“The investor who simply sought out low-cost funds, then, enjoyed an amazing increase in annual risk-adjusted return from 8.1% to 11.9%, an enhancement of nearly 50% per year,” he wrote. Compounding the higher costs of the more expensive returns simply reduced their long-term returns, he notes.

Each dollar invested in a high-cost fund grew to $2.18 over the 10-year period. Meanwhile, each dollar invested in a low-cost fund grew to an average $3.07. “Fund investors would have improved their 10-year profit by 75%, simply by doing their fishing in the low-cost pond,” he wrote.