Why Fund Costs Matter More Than Past Performance
When it comes to , almost everyone—from financial advisors to the media—points to a fund’s past performance as the key indicator of success. We’re taught to look at the track record to predict future results. But deep down, we know that performance is fickle; it comes and goes. This is a crucial lesson for anyone .
There’s a much more powerful and persistent factor that shapes your returns, and it’s one that’s often overlooked: the cost of owning the fund. While performance is temporary, costs are forever. If you want to get better at picking winning funds, your focus shouldn't be on the fleeting glow of past returns but on the one thing that has consistently shaped outcomes throughout history: how much you pay.
The Three Costs That Quietly Drain Your Returns
So, what are these costs? They fall into three main categories.
First is the expense ratio, which is the most well-known fee. This percentage rarely changes much. Funds with high expense ratios tend to stay that way, and low-cost funds generally remain low-cost.
Second, you have sales charges, or “loads,” paid each time you buy shares. These fees are almost always ignored in published performance data, but they create a persistent drag on your investment. A fund that charges a load fee isn't likely to suddenly become a no-load fund.
Finally, there's the cost of portfolio turnover. Every time a fund manager buys or sells securities, it costs money. A simple rule of thumb is to assume that a fund’s turnover costs about 1% of its turnover rate. So, a fund with 100% turnover—meaning it replaces its entire portfolio in a year—incurs an extra 1% drag on your returns. A fund with 10% turnover slashes that cost to just 0.10%. In 2016 alone, equity funds spent an estimated $66 billion on trading, which works out to an annual cost of about 0.8% of their total assets.
The Undeniable Link Between Costs and Performance
When you start looking, the evidence is overwhelming. Even when you only consider expense ratios, studies consistently show that higher costs lead to lower returns. This holds true across every category of fund, from large-cap to small-cap.
But when you also factor in the hidden cost of portfolio turnover, the connection between what you pay and what you earn becomes dynamite. Combining these two expenses reveals that actively managed equity funds can have all-in annual costs ranging from 0.9% for the cheapest quarter of funds to 2.3% for the most expensive.
Costs matter. A lot.
A 25-year study of equity funds drives this point home. The lowest-cost funds delivered an average net annual return of 9.4%, while the highest-cost funds returned just 8.3%. What’s fascinating is that before accounting for costs, the returns for both groups were nearly identical—around 10.3% to 10.6%. This shows that the fund managers weren't any better at picking stocks; the entire difference in what investors actually received was eaten up by fees.
There's more. As costs go up, so does risk. The lowest-cost funds were significantly less volatile than their high-cost counterparts. When adjusted for risk, the cheapest funds outperformed the most expensive ones by a full 1.5 percentage points per year.
The Long-Term Impact of Small Fees
That 1.5% might not sound like much, but thanks to the magic of compounding, it creates a massive gap over time. Over the 25-year period, the lowest-cost funds grew an initial investment by 855%. The highest-cost funds? Only 632%. That’s a 35% larger return, almost entirely due to lower fees. This is a core principle of ; small, consistent advantages add up to enormous differences.
An analyst at Morningstar confirmed this in no uncertain terms, stating that expense ratios are the most dependable predictor of performance. In every single time period and data point they tested, low-cost funds beat high-cost funds. If you’re figuring out , making expense ratios a primary test in your fund selection process is one of the smartest moves you can make.
The Logical Next Step: Index Funds
If the data overwhelmingly proves that lower costs lead to better returns, why stop at just active funds? The logical conclusion is to seek out the absolute lowest-cost option available: the traditional index fund.
These funds, designed to simply mirror a market index like the S&P 500, often have total costs around 0.1%. Looking at the same 25-year period, the S&P 500 index fund’s net return was 9.1% with lower risk than any of the active fund groups. These are some of the most reliable you can find.
Here’s the kicker: the performance numbers for the active funds in that study were inflated. The data only included funds that survived the full 25 years, a phenomenon known as “survivorship bias.” If you account for all the funds that failed and shut down, the average return for active funds would have been even lower. To effectively, minimizing costs is paramount.
The math is clear. The more that managers and brokers take from your investment, the less you get to keep. When they take next to nothing, you get to keep everything the market offers.
As far back as 1995, Tyler Mathisen, now at CNBC, wrote about this, admitting he and other journalists had long ignored Vanguard founder John Bogle’s praise for boring, low-cost index funds. He concluded, “Gunning for average is your best shot at finishing above average.” It’s a paradox, but it’s one of the most reliable truths in .
