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How important are mutual fund expenses really?

You've probably seen articles explaining that mutual fund investors pay higher costs than they realize due to funds incurring "hidden" costs that aren't reflected in the published "expense ratio." Such articles (here's a recent example from Morningstar) usually disparage funds that do a lot of trading because they tend to incur higher levels of these "hidden" costs.

The argument is true to a point: Any investor who selects funds primarily based on their stated expense ratios probably isn't aware of potentially expensive trading costs or 12b-1 fees (i.e., marketing expenses) that aren't reflected in those ratios.

But is that the best way to select funds in the first place?

At Sound Mind Investing, we take a different approach to the issue of expenses. Brace yourself — we're not all that concerned about them. It's not that they don't matter — they certainly do. It's just that we're much more concerned about overall performance. If we wind up paying higher expenses as part of the price of obtaining better overall performance, that's a trade we're willing to make.

The types of articles mentioned above usually don't present it that way. They argue that if Fund A has high trading costs, Fund B has a high 12b-1 fee, and Fund C has neither, then you should invest in Fund C. That would be true if A, B, and C all generated the same performance. But if A and B strongly outperform C — so that you come out ahead even after expenses are subtracted — then, relatively speaking, the expense levels of A and B weren't all that important.

Fundamentally, this issue boils down to two competing belief systems. On one side, you have those who say it's virtually impossible to determine in advance which funds will outperform in the future. Therefore, the only approach that makes sense is to diversify and minimize expenses. This is the basic essential argument for indexing.

On the other side, there are people like us who say you can predict which funds will outperform in the future. Not every time. And trying to do so doesn't afford you the luxury of buying a fund and holding it for years or decades at a time. But over time, we do believe it's possible to get a market-beating result if you're willing to stick rigorously to a specific discipline of buying and selling funds. We call this discipline our Fund Upgrading strategy.

So how can you know in advance that A and B will perform better than C? You can't know for sure, not on any single fund choice. But research has shown that recent mutual fund performance tends to persist into the short-term future. In other words, superior recent performance tends to translate into superior near-term future performance. That's the basis of Upgrading.

It certainly doesn't work on every single fund selection. That's why we have to follow a vigorous selling discipline as well, to cut our losing trades short. But over time, the Upgrading process steers us towards enough funds that outperform their peer group.

That's how our Upgrading has been able to beat the market in 10 out of the past 11 years (in the graph below the light-shaded bars represent the performance of the overall market as measured by the Wilshire 5000; the dark-shaded bars represent Upgrading's performance).

Further, as noted in the current issue of SMI, Upgrading is a strategy that works remarkably well even when implemented on limited scale.

At the end of the day, our emphasis is not on expenses and costs, but rather on the final returns a fund produces after already accounting for all the costs of ownership. It's not that we don't care about expenses, it's that all of a fund's costs are already baked into the performance numbers we use as the basis of Upgrading. So if a fund can outperform in spite of higher costs, we're willing to overlook them.

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