Much as we would like to identify, in advance, the funds that are going to  produce the best returns, it is exceedingly hard to do in practice. Sure, you might just be lucky enough to pick one of the big winners of the future. But you could just as easily pick a total bust and end up losing money.

But let's say you did want to give it a try. What metrics would you use to choose between different funds?

Most people in this situation focus on past performance. Indeed, we're encouraged by the financial media to do so. The money pages are full of examples of funds with impressive recent returns which seem like a sensible bet.

Success Is Hard to Reproduce

The problem is, almost all active fund managers struggle to replicate their past successes. Often, they earn "star" status off the back of just one or two years of beating the market, or, to use the technical term, delivering alpha. In some cases, their reputation rests on just one month of extraordinary returns.

In Step 5 of his book Index Funds: The 12-Step Recovery Program for Active Investors, Mark Hebner uses the analogy of movie sequels to explain just how unusual it is to for managers who have hit the jackpot to do so again.

"Men in Black II, Ocean's Twelve and The Hangover, Part II," he writes. "All of these movies have one thing in common: they were abysmal sequels to blockbuster movies. We long to regenerate scenarios when everything comes together perfectly and the stars align, but that kind of success is rarely duplicated.

"As hard as it is to (do) in the film world, it is even more difficult for these all-star money managers to duplicate their past success."

Past performance, in other words, tells us very little, if anything, of value about future performance.

The Most Reliable Predictor Is Cost

In 2016, Russel Kinnel, Director of Mutual Fund Research at Morningstar published a landmark study which found, of all the variables he tested, expense ratios did the best job of predicting funds' subsequent returns. Simply put, the lower the fees were, the better funds tended to do versus peers over subsequent periods.

But has that held true over the nine-year period since then? Morningstar's Chief Ratings Officer Jeffrey Ptak has recently studied the numbers for both stock and bond funds for the 20-year period to the end of January 2025, and the answer is an unequivocal Yes.

Ptak categorized funds based on their expense ratios at various points over the period, from the cheapest to the priciest. He then analyzed the subsequent net-of-fee returns for each group.

What he found bolstered Kinnel's findings in 2016. He writes: "Not only did cheaper funds outperform, on average, the sort from low-cost to high-cost followed an almost perfect stair-step pattern. That pattern held when I measured stock and bond funds separately.

"Moreover, the cheapest funds subsequently outperformed the priciest funds, on average, in every single year that spanned the study."

Ptak says the key takeaway for investors is obvious: "Investors choosing funds should start with fees, favoring those that levy lower expense ratios than peers.

"Russel Kinnel's research made that clear, and these more recent findings seem only to reinforce the case he originally made to pinch pennies."

Index Funds Are Much Cheaper

This is one of the reasons why IFA recommends using index funds, not actively managed funds. Active funds are more expensive than both traditional index funds and the non-traditional variety which we particularly favor, and the difference in annual management fees can be very considerable.

Remember, too, that the headline fee is only part of what the investor pays. In Step 7 of his book, Mark Hebner provides a list of what he calls "silent partners" investors in active funds pay money to. These include stockbrokers, investment advisors, accountants, market makers, transfer agents, mutual fund distributors, and income tax agencies.

"Your investment portfolio is vulnerable to these silent partners," writes Hebner. "Ideally, a silent partner would provide some sort of benefit, but in the case of your investments, these silent partners add little value."

Unlike active funds, index funds keep trading to a minimum, which substantially reduces your costs. On top of that, index funds are also more tax efficient.

Time For A Rethink?

The veteran investment consultant and best-selling author Charles Ellis was one of the first people, in the 1970s, to point out that net of costs, very few active managers outperform index funds. Now 87, Ellis has just published a new book, Rethinking Investing, in which he says he is more certain than he has ever been that your best interests are served by investing in index funds.

"The average investor committed to active investment management," Ellis writes, "can lose as much as 2-3% in return per annum through a combination of costs charged by active managers and extra taxes, plus the self-imposed injuries by their (own behavior).

"Over the very long-term, that slippage can compound to evaporate a third or more of what might have been the investors' final assets.

"To maximize your returns, you should attack in the opposite direction and work diligently to avoid or minimize costs, fees and taxes that fund managers or the government impose on you. The long-term impact is huge!"

---

ROBIN POWELL is IFA's Creative Director. He always works as a freelance journalist and author, and as Editor of The Evidence-Based Investor.

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal.  Quotes and pictures are utilized for illustrative purposes only and should not be construed as an endorsement, recommendation, or guarangee of any particular financial product, service, or advisor. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.