Do high-cost funds pay off?

(Money Magazine) -- Question: I'm trying to choose between two funds in my 401(k) that invest in the same sector. One has higher fees, but it also performs better. How can I tell if a fund's performance is worth the higher price? --Jordan, San Antonio, Texas

Answer: I've been telling investors for years that they're better off sticking to low-cost funds whether they're buying them for a 401(k), IRA or, for that matter, any type of account.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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In one recent column I even gave an example of how large-company stock funds with relatively low annual expenses outperformed large-cap funds with higher yearly tariffs by 1.3 percentage points a year over a 15-year period. On a $50,000 investment, that margin could mean the difference between ending up with $150,000 vs. $125,000.

And if anything, the value of a strategy of opting for funds with slim expense ratios vs. those with heftier ones just got even more "street cred" with the release last week of a study by Morningstar titled "How Expense Ratios and Star Ratings Predict Success."

I'll spare you the nitpicky details since you can read them for yourself. But here's the bottom line: Whether it was domestic stock funds or international, taxable or municipal bond portfolios, low-cost funds beat their high-fee counterparts in every single time period tested in the study. Morningstar even concluded that expenses were a better predictor of a fund's future performance than its widely followed star-rating system.

But does that mean in every fund with lower expenses will outperform every other comparable fund with higher fees?

Of course not. The Morningstar study ranked funds by their expense levels and then divided them into quintiles, with funds in the first quintile having the lowest expenses and the funds in the fifth quintile the highest. It then compared the performance of the quintiles.

Given the huge number of funds, variety of time periods and varying differences in expense levels, there will always be exceptions to the general rule that low-fee funds do better than those with high-fees. You cite just such an instance where the high-cost fund outperformed one with lower expenses.

This can happen for any number of reasons. Even though they have similar investment strategies, two funds may still have somewhat different holdings that account for the performance gap over a given period. One fund might focus more on the biggest of the big caps or smallest of the small fry. If the market happens to prefer a particular niche over a certain period, then one might outperform the other despite having loftier expenses -- at least for as long as market conditions favor its particular holdings.

Differing risk levels can also matter. Just because two funds invest in the same sector, doesn't mean they take comparable risks. One may invest much more aggressively, or conservatively, than the other. In rising markets, a more aggressive high-fee fund may be able to beat a similar low-cost one that takes a more conservative stance; the reverse can be true in weak or down markets.

I'll even allow that differences in manager skill might account for superior performance -- that is, a savvier manager may be able to overcome the drag of higher costs and outperform lower-cost rivals. The question is for how long?

For example, Bill Miller trounced both the Standard & Poor's 500 index and most of his competitors with his Legg Mason Value (LGVAX) fund from the early '90s through the mid 2000s even though the fund's expense level, while hardly onerous by fund standards, wasn't the slimmest either. Since that incredible run came to an end in 2006, however, the fund hasn't exactly been a powerhouse.

Fact is, it's always hard to tell in the case of actively managed funds what's driving better performance. Is it low fees? Superior stock picking? A more aggressive or conservative strategy? Simple luck or randomness? Market researchers have debated such questions for years -- a recent paper takes on the luck vs. skill question directly -- and no doubt will continue to do so for years to come.

At this point, I think it's fair to say that managers who outperform due to true skill are few and far between and identifying them in advance is extremely difficult. For most investors I think distinguishing between luck and skill is essentially a guessing game, which is one reason I believe most investors are better off opting for low-cost index funds.

But back to your question.

I don't want to tell you to drop a fund that's done well for you simply because it has higher costs than another one you're considering. You don't say how big the fee difference is. If it's relatively small -- say, 0.75% vs. 0.85% -- it may be a moot question altogether.

But if the gap is significant -- and you can argue about what's "significant," but let's say 50 basis points or more -- then I would want to take a closer look at both funds to see what, if anything, might account for the difference.

You can compare their portfolios by going to the Portfolio X-Ray tool.

I'd be surprised if you don't find some substantial discrepancy between the portfolios. Once you know more about the two funds, you can decide whether you're still comfortable with your choice.

If you decide you still want to hold onto the higher-cost fund, fine. But if I were you, I'd keep an eye on it and be ready to make a switch (which will have no tax consequences within a tax-deferred account).

Because, all else equal, the bigger the expenses, the higher the hurdle a manager has to overcome to keep pace with similar funds. And just because a manager has been able to clear that obstacle in the past, doesn't mean he or she will be able to do so consistently in the future. If anything, the odds are against it.