NEARLY ALL FUND EXPERTS, advisers to investors, the financial media, and investors themselves rely heavily—indeed almost to the exclusion of other information—on selecting funds based on their past performance. But while past performance tells us what happened, it cannot tell us what will happen. Indeed, as you will later learn, emphasis on fund performance is not only not productive; it is counterproductive. Our own common sense, deep down, tells us: Performance comes and goes.

But there is one powerful factor in shaping fund returns, often ignored, that is essential to know: You can be more successful in selecting winning funds by focusing, not on the inevitable evanescence of past performance, but on something that seems to go on forever or, more fairly, a factor that has persisted in shaping fund returns throughout the fund industry’s long history. That factor is the cost of owning mutual funds. Costs go on forever.

Fund performance comes and goes. Costs go on forever.

What are these costs? The first and best known is the fund’s expense ratio, and it tends to change little over time. Although some funds scale down their fee rates as assets grow, the reductions are usually sufficiently modest that high-cost funds (average expense ratio of the highest-cost decile funds, 2.40 percent) tend to remain high-cost; lower-cost funds tend to remain lower-cost (fourth decile average expense ratio, 0.98 percent), and the few very low-cost funds tend to remain very low-cost (lowest-cost decile average expense ratio, 0.32 percent). The average-cost funds in the fifth and sixth deciles (1.10 percent and 1.24 percent) also tend to persist in that category.

The second large cost of equity fund ownership is the sales charge paid on each purchase of shares. The drag of sales loads is almost invariably ignored in the published data, although it, too, tends to persist. Load funds rarely become no-load funds, and vice versa.¹ (I can recall no large fund organization making the immediate conversion from a load to a no-load distribution system since Vanguard took that unprecedented step way back in 1977.)

The third major cost incurred by fund investors is the cost of the purchase and sale of portfolio securities. These transactions cost money. We estimate that turnover costs are roughly 0.5 percent on each purchase and each sale, meaning that a fund with 100 percent portfolio turnover would carry a cost to shareholders of about 1 percent of assets, year after year. Similarly, 50 percent turnover would cost about 0.50 percent per year of a fund’s returns. A 10 percent turnover would slash the cost to 0.10 percent, and so on.

Rule of thumb: assume that a fund’s turnover costs equal 1 percent of the turnover rate. In 2016, purchases and sales of portfolio securities in equity mutual funds totaled $6.6 trillion, equal to 78 percent of average equity fund assets of $8.4 trillion. The cost of all that trading, often among competitors, came to something like $66 billion, an annual cost equal to 0.8 percent of fund assets.

Costs are large, and too often ignored.

Most comparisons of fund costs focus solely on reported expense ratios, and uniformly find that higher costs are associated with lower returns. This pattern holds not only for equity funds as a group, but in each of the nine Morningstar style boxes (large-, mid-, and small-cap funds, each sorted into three fund groups with either growth, value, or blended objectives).

While few independent comparisons take into account the additional cost of fund portfolio turnover, a similar relationship exists. Funds in the lowest-turnover quartile have consistently outperformed those in the highest-turnover quartile for all equity funds as a group, and in each of the nine style boxes.

Adding these estimated turnover costs to each fund’s expense ratio makes the relationship between fund costs and fund returns sheer dynamite. Taking into account both costs, we find that all-in annual costs of actively managed equity funds range from 0.9 percent of assets in the lowest-cost quartile to 2.3 percent in the highest-cost quartile, as shown in Exhibit 5.1. (This exercise ignores sales charges and therefore overstates the net returns earned by the funds in each quartile.)

Costs matter. A lot.

Costs matter! Exhibit 5.1 shows a 1.4 percent difference between the average expense ratio of funds in the highest-cost quartile and the lowest-cost funds. This cost differential largely explains the advantage in returns among the lowest-cost funds over the highest-cost funds. During the past 25 years: average net annual return of lowest-cost funds, 9.4 percent; net annual return of highest-cost funds, just 8.3 percent, an enhancement in return achieved simply by minimizing costs.

Note, too, that in each of the fund quartiles, when we add back fund costs to the funds’ reported net returns, the gross annual returns earned in each category are virtually identical. Those gross returns (before costs) fall into a narrow range: 10.6 percent for the highest-cost quartile and 10.3 percent for the lowest-cost quartile, just what we might expect. In each quartile costs account for essentially all of the differences in the annual net returns earned by the funds.

There is yet another significant difference. As costs increase, so does risk. Using the volatility of annual returns as the measure of risk, the lowest-cost funds carried significantly less risk (average volatility of 16.2 percent) than their highest-cost peers (17.4 percent). When we take that reduction in risk into account, the risk-adjusted annual return for the lowest-cost quartile comes to 8.9 percent, fully 1.5 percentage points higher than the 7.4 percent risk-adjusted return of the highest-cost quartile.

The magic of compounding, again.

That 1.5 percent annual advantage in risk-adjusted return may not seem like much. But when we compound those annual returns over time, the cumulative difference reaches staggering proportions. The compound return for the period is 855 percent for the lowest-cost funds and 632 percent for the highest-cost funds, an increase of more than 35 percent, a superiority arising almost entirely from the cost differential. Talk about the relentless rules of humble arithmetic!

In other words, the final value of the lowest-cost funds multiplied the original investment more than eightfold, while the highest-cost quartile returns were multiplied about sixfold. Surely “fishing in the low-cost pond” should enhance your returns, and by a wide margin at that. Again, yes, costs matter!

Are we overstating the importance of fund costs? I think not. These next few paragraphs from a respected analyst at Morningstar confirm my conclusions, and then some:

If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.

Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.

Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you’ll be on the path to success.

Low costs and index funds.

But if you are persuaded by this powerful affirmation that, yes, costs matter, and decide to focus on the lowest-cost group of funds, why limit the search to actively managed funds? Traditional index funds (TIFs) had the lowest costs of all: expenses averaging just 0.1 percent during this period. With no measurable turnover costs, its total all-in costs were but 0.1 percent. The gross return of the S&P 500 Index fund was 9.2 percent per year; the net return, 9.1 percent. Carrying a lower risk than any of the four cost quartiles (volatility 15.3 percent), its risk-adjusted annual return was also 9.1 percent, a cumulative gain that ranked the index fund ahead of even the lowest-cost quartile funds by 0.2 percent per year.

If the managers take nothing, the investors receive everything: the market’s return.

Caution: The index fund’s annual risk-adjusted return of 9.1 percent over the past 25 years is all the more impressive since the returns of the active equity funds are overstated (as always) by the fact that only the funds that were good enough to survive the decade are included in the data. Adjusted for this “survivorship bias,” the return of the average equity fund would fall from 9.0 percent to an estimated 7.5 percent.

What’s more, selecting the index fund eliminated the need to search for those rare needles in the market haystack represented by the very few active funds that have performed better than that haystack, in the often-vain hope that their winning ways will continue over decades yet to come.

As Morningstar suggests, if investors could rely on only a single factor to select future superior performers and to avoid future inferior performers, that factor would be fund costs. The record could hardly be clearer: The more the managers and brokers take, the less the investors make. Again, if the managers and brokers take nothing, the investors receive everything (i.e., the total return of the stock market).