When an informed consumer buys an item, they know its complete price. But when that same informed consumer buys an equity mutual fund for their retirement, they don’t know its true cost.

That’s because funds charge a variety of fees that are cumulative and often change over time. The Securities and Exchange Commission has found that for each 1 percent of increased expense level in a fund, its annual return drops not just 1 percent, but 1.9 percent. To compound the problem, the longer an investor owns a fund, the more the shareholder pays in total expenses

In practice, this means shareholders who buy “top-performing” funds with high expense ratios face two big problems:

• Fund ranking systems which do not include the impact of total expense ratios over time are misleading:
• Funds with lower expenses and lower performance rankings can prove superior to top-ranked funds that carry high expenses over time.

Specifically, this problem resides at Morningstar Inc. (NASDAQ: MORN) the nation’s largest purveyor of investing information to individual investors. Yet according to Russel Kinnel, Morningstar’s  director of mutual fund research, total fund expenses are not used to calculate a fund’s top performance rating.

In his article, “The Star Rating Performs Well but Our Picks Are Better,” Kinnel wrote that Morningstar’s current ranking system could be improved if a fund’s total expense ratio over time was included in the ranking criteria. The impact of expenses is so significant that funds with lower performance and lower expenses could easily move up in rankings over time. 

Conversely, an equity fund investor who relies on the current Morningstar rankings to buy a five-star fund carrying a high expense ratio might see benefits erode over time as expenses cut into total performance. 

“In other words, if you buy funds that have the cheapest-quartile costs and 5 stars, you have a much greater chance of getting a mutual fund that will survive and outperform its peers,” according to Kinnel.

Re-Thinking the Morningstar Rating System

The main problem is that Morningstar’s rating system only uses three years of a fund’s most recent performance. But equity funds are designed to be long-term (five years or more) investments, so Morningstar’s three year performance snapshot should be considered a short time period.

As a result, Kinnel said this short time period understates a fund’s “negative compounding effect of expense ratios.”

“Over time, the difference between a 0.60 percent expense ratio and a 1.25 percent expense ratio can lead to a very big sum after 20 years, but not so much for three years. In addition, expense ratios change over time, and the fund’s most current expense ratio, rather than past expense ratios, is the best indicator of where it will be in the future,” he added.

So what does this mean to equity mutual fund investors who rely on Morningstar’s rating system?

First, don’t take the Morningstar ratings at face value. Investors must consider the fund’s expense ratio as an essential element of its overall rank. They also must factor in how long they plan to own the fund.

In his research, Kinnel looked at Morningstar’s top-rated group and concluded that funds in the cheapest quartile had  higher three- and five-star ratings over the next three or five years 80 percent of the time. “Factoring out the survivorship bias, the success ratio was improved 90% of the time when the expense screen was added in,” he said.

“I can think of a number of things that might improve the star rating’s predictive power, but the one I’m certain of is factoring in expense ratios. Slicing the 5-star groups to include just those funds in the cheapest quartile of their category led to higher three- and five-year star ratings over the next three or five years 80% of the time. Factoring out the survivorship bias, the success ratio was improved 90% of the time when the expense screen was added in.”