Enhancing Equity Index Mutual Fund Returns Using Cost and Morningstar Ratings Information

Abstract

Although equity index mutual funds (EIMFs) are often viewed as a commodity, we analyze the impact that differences in expenses and other fund characteristics have on both past returns and forward-looking ratings. Morningstar evaluates past performance with their “star” rating and evaluates future fund prospects using analyst ratings (ARs) and quantitative ratings (QRs). Funds with low expense ratios and no loads earn higher returns without adding proportionally higher risk. Morningstar analysts carefully consider fund fees in their evaluations and assign much higher ARs to lower-cost funds. Interestingly, although loads initially appear to negatively impact these ratings, once expense ratios are controlled for, analysts seem to be favorably disposed to funds with loads. Regression analysis further suggests that ARs are also positively influenced by Morningstar ratings and fund size. QRs are positively influenced by past performance, but negatively correlated with loads and expense ratios. EIMF age has little influence on AR and QR levels, though the likelihood of an AR rating increases with time since inception. Similar results occur in both the US and foreign equity markets. Expense ratios, loads, past performance, and size can all be used as fund selection tools that aid in maximizing investor wealth.

Key Findings

• ▪ When investing in US or foreign equity index mutual funds (EIMFs), investors can enhance returns by reducing fund-related expenditures. These include loads, which occur prior to investment.

• ▪ The individual benefits of lowering loads and expenses exist whether looking backward with Morningstar “Star” ratings or looking forward using either analyst ratings (ARs) or algorithms based on investment “pillars,” which Morningstar defines as quantitative ratings (QRs). However, analysts seem willing to incur loads when considering loads and expense ratios in tandem.

• ▪ Forecast returns are higher for EIMFs with higher historical returns and EIMFs that have a larger amount of assets under management.