S&P Study Shows Cheaper Funds Outperform IndexFunds.com Staff June 13, 2003

A new study by Standard & Poor's shows that when choosing funds, investors would be well served to research how a fund stacks up against its peers in terms of costs. S&P reported that, on average, funds with lower expense ratios have outperformed their more expensive peers in eight out of the nine domestic fund style categories over a one, three, five, and ten-year annualized basis. The only exception was the Mid-Cap Blend investment style, where funds with a higher expense ratio outperformed their less expensive peers on a one, five, and ten year annualized basis.

"Investors don't always take expenses into account when selecting a mutual fund because they are typically stated in percentage terms - making it harder to translate in a meaningful way," said Phil Edwards, head of fund research at S&P. "Investors need to pay closer attention to expenses, especially in a market environment where returns are expected to be in the single digits. It is in this type of setting that expenses can take a larger proportion of a fund's return."

S&P started by determining average expense ratio for each of the nine domestic fund style categories. It then sorted the funds in each of the nine style categories into two groups - those with an expense ratio below the average of their peers and those with an expense ratio that was higher. It then compared the average annualized return for each of the two groups over a one, three, five, and ten-year performance period to determine if a fund's return justified the level of its expenses over the long term. S&P found that for funds with larger than average expense ratios, a higher return was not necessarily something investors wound up with in eight of the nine style categories.

The results support previous studies S&P has conducted in overseas markets. S&P spokesman David Guarino said a team at the firm's European fund research group recently concluded a similar study.

"They came up with almost exactly the same results for European funds," he said.

However, Guarino noted, "There may be funds out there whose returns really do justify higher expenses." A lower expense ratio does not guarantee better performance, but S&P's results demonstrate that investors should choose among cheaper funds if they can.

The table below shows how active funds, index funds, and exchange-traded funds stack up in terms of average expense ratio.

Expenses of ETFs vs. Open-End Mutual Funds
Category	Average expense ratio
Exchange-Traded Funds
U.S. Major Market ETFs	0.18%
U.S. Style ETFs	0.23%
U.S. Sector ETFs	0.34%
All U.S. Equity ETFs	0.28%
International Equity ETFs	0.41%
All Equity ETFs	0.40%
Fixed Income ETFs	0.15%
Open-end Mutual Funds
Actively Managed Domestic Equity	1.40%
Actively Managed International Equity	1.94%
Passive/Indexed Domestic Equity	0.75%
Passive/Indexed International Equity	0.95%
Passive/Indexed Fixed Income	0.39%

Source: Morgan Stanley Equity Research