The ever expanding universe of mutual funds has grown so large it is almost beyond comprehension.  Today, there are hundreds of fund companies offering thousands of mutual funds, all claiming that their team of experienced experts know something the rest of the experts have overlooked in their never-ending search for value-added returns. There are actually more U.S. large-cap mutual funds than the total number of companies contained within the entire universe of U.S. large-cap stocks. Talk about looking for a needle in a haystack! What do any of these fund managers know that the others don’t already know about these public companies?  Very little. Yet that doesn’t stop them from claiming superior insight or skills which could deliver market-beating performance as they seek to uncover value the rest of the herd overlooked.

Investors will typically use performance as the primary condition for selecting a fund.  Unfortunately, they may be perpetually disappointed because a fund with above average returns today will more than likely under-perform over the next market cycle.  What then is an investor to do - throw darts? You could, but there is a better strategy.  The single best factor to consider when selecting a fund is to look at costs before anything else. Don’t take my word for it, ask Morningstar, the independent research firm.  In a recently updated report they state that the expense ratio is the most proven predictor of future fund returns.

In conducting their research, Morningstar used historical data which is what investors would have had access to at the time, and which included funds that no longer exist.  Since each year about 20% of funds don’t survive, they must also be included to get an accurate picture. Morningstar first separated funds by category and then grouped them into quintiles (which are five groups, each representing 20%) by expense ratios from least to most expensive. Next they compared returns with expenses and found that the lower-cost funds beat higher-cost funds in every category.  Not only that, there was a perfect correlation between expenses and returns.  For example, the quintile with the highest returns had the lowest expenses.  The second-highest returns had the second-lowest expenses and so on down to the bottom quintile which had the highest fees and worst returns.  This correlation held true for every category of funds measured with no exception.  Go figure.

The folks at Morningstar, who know a thing or two about mutual funds, have been conducting this study for years and the results are always the same.  Yet many investors still believe there are experts out there who can consistently deliver superior returns due to some unique insight or strategy and are willing to pay unnecessary fees in pursuit of that performance.  You really could do as well throwing darts when selecting funds as compared to using past performance as your guide. If you want a sound fund selection strategy, then consider funds that have the lowest expense ratios and leave the dart throwing for the unconvinced.