Updated June 2023.
Like many financial behemoths that cannot take a position one way or another for fear of alienating a big chunk of their customer base (which helps Morningstar but hurts consumers) - Morningstar's latest report, May 2016, covered in Financial Advisor magazine ignores a very important point - the "Elephant in the room". (By the way the magazine's author also ignored the "Elephant" for the same reason as Morningstar.)
As reported by Financial Advisors magazine author Christopher Robbins May 10, 2016, there is a perfect correlation to fund performance and the fund's expense ratio.Robbins reported Morningstar's results:"
Across every asset category, including international equities and sector equities, the funds with the lowest expense ratios recorded the best performance over three, four and five-year time periods, and when comparing any two quintiles within a category, the lower-expense funds outperformed the more expensive ones without exception. Funds with lower expense ratios tend to have longer lifespans, according to Morningstar."
OK, so what's the "Elephant"? Simple - index funds have the lowest expense ratios - far lower than conventional funds. So this report, for all practical purposes, is yet more proof that actively managed or "conventional" funds under-perform index or "evidence-based" funds. Unfortunately, Morningstar does not want to take a position in the "conventional vs. evidence-based" debate - so their study did not address that specific issue.
There are so many wonderful aspects about owning an completely independent RIA firm. One of my favorites: I can communicate completely, candidly and with completely clarity on important topics without concern of offense.
So please hear this message:
Dear Readers: I am looking into your eyes with the most sincere expression on my face and in my heart and I am saying and writing:
"THERE IS NO DEBATE HERE! Evidence Based Investing BEATS conventional investing.
A caveat is that across any time period you can find active funds that guessed correctly and happened to be overweight in areas that performed higher and thus beat the most relevant benchmark which is effectively the same as beating the most relevant index fund. The problem is that 60-90% of the time, their guesses are wrong. You have to guess correctly on choosing which fund manager will guess correctly - before there is any indication that they can guess correctly! They also rarely accomplish the "lucky guess" feat consistently - just occasionally at best. And if you have found an active manager that will win in the future, they will hit periods of poor performance. Will you have the discipline to stick with them during those times. It is very unlikely!
Recent research (see here) showed that funds that have recently done well are more likely to perform below average in the near term and the opposite is true too! This is the roller coaster ride of conventional investing - your lucky guess priding lucky performance goes away and you have under-performance.
When looking at the research presented above please consider this. For 401(k) plans that use actively managed funds, almost all with less than maximum diversification, they evaluate funds regularly. When evaluating funds they look at performance and over a short time period like 1-3 years. They may remove a fund that recently performed poorly and replace it with the opposite, a fund that has recently performed well. The above research says that may be exactly the wrong move! The problem is that past performance is a bad indicator! The best indicator is the fund’s internal expense level and diversification. And using actively managed funds is like gambling because there’s no way to have an expectation of long term return.
Disclaimers: No one should or can accurately make claims about any future investment performance. We can share the latest research. Research shows that diversification is important and that is why you see diversification specifically referenced in many regulations involving investing. Research also shows that so far, mutual fund expense ratios appear to be a positive indicator of future relative performance. Research also shows that recent fund performance is a very poor indicator and in fact could be a “contra-indicator”.