Low Costs are the Smartest Investment

While you can't control the market, you can control your costs--and the impact they have on your total returns

Ben Johnson 8 March, 2010 | 2:13PM

Take control
As an investor, you could not have done anything to prevent the late '90s tech bubble or the collapse of Lehman Brothers. The resulting declines and subsequent rebounds in global financial markets were similarly beyond your control (although you could have taken an antacid to mitigate the effects on your stomach). And while you won't be able to shape future events that move financial markets, nor the markets themselves, you can control the price that you pay to participate in those markets. In fact, minimising costs has proven one of the most effective ways to consistently outperform the average fund over an extended time horizon. And the best part is that your investment costs are more within your control than any other aspect of investing.

Investment management costs defy conventional economic logic. A more expensive fund isn't likely to outperform a less expensive one the way you would expect a Ferrari to outstrip a Peugeot. When confronted with two investment options--one sporting an annual expense ratio of 1.5% and the other 0.25%--the only guarantee is that you will pay an additional 1.25 percentage points to invest in the former. Virtually every study we have seen of funds has shown that funds charging higher fees tend to underperform those with lower fees. In fact, the fund's expense ratio is the single greatest predictor of fund performance--greater than past performance, and even greater than our star rating (though using low fees with our star rating proves a powerful combination). Whether investing in equities or fixed income, large capitalisation companies or small, and regardless of geography, the lowest cost funds have consistently outperformed their more expensive peers.

ETFs are low-cost leaders
One of the most appealing features of exchange-traded funds (ETFs) is their low costs. The average total expense ratio (TER) for European equity ETFs is 0.37%, less than half the annual cost of the average equity index fund (0.87%) and about one-fifth of the cost of the average actively-managed equity fund (1.75%). While these cost differentials are substantial at first blush, they become even greater as they compound over time. Let's use these three averages to show the benefits from minimising costs over an extended time horizon.

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About Author

Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.

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