Low-cost funds outperform high-cost funds, research shows

Lower prices are often synonymous with value. Surprisingly, the same is true when selecting investments. Look for the lowest-priced, diversified exchange-traded funds (ETFs), the cheapest mutual fund or any investment vehicle or manager that ranks among those with the lowest costs. For top long-term returns, be more focused on the cost of your investments than in seeking the top-performing fund.

How can I make such a definitive statement? Because the research supports it.

Morningstar reports that the average actively managed stock mutual fund sports an annual expense ratio of more than 1.4 percent. (Compare that to the average ETF fund fee of 0.2 percent.) If we assume a long-term return on stocks of approximately 9 percent and an average annual inflation rate of 3 percent, we obtain a real rate of return of 5.8 percent annually. Before accounting for the compounding of the expense ratio — yes, fees compound and erode total return just as dividends and interest compound and increase total return — you can see that an average annual fee of 1.4 percent consumes a significant portion of the average annual real total return of stocks of 5.8 percent.

William Sharpe, winner of the 1990 Nobel Prize in Economic Sciences, published a 2013 paper titled "The Arithmetic of Investment Expenses" in which he concludes "a person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20 percent higher than that of a comparable investor in high-cost investments."

The Department of Labor published an analysis of the effects of 401(k) fees on long-term investor returns (available on the DOL's website). The study assumes an individual with a 401(k) balance of $25,000, with 35 years remaining to retirement who pays an investment management fee of 0.5 percent (well below the Morningstar average fee) and earns 7 percent per year on those funds. At the end of the 35-year period and assuming no additional contributions, the balance will grow to $277,000. However, when the fee is increased to 1.5 percent — all other assumptions remaining constant — the account balance grows to $163,000, or $114,000 less than the portfolio paying the lower fee.

Russel Kinnel, director of manager research at Morningstar argues "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."

In short: High fees are one of the most dependable predictors of underperformance. So pay attention to fees and you will increase your retirement wealth.

Nancy Tengler spent two decades as a professional investor. She is a financial-news commentator and university professor and the author of "The Women's Guide to Successful Investing." Reach her at nancy.tengler@cox.net.