Are Expense Ratios a Dependable Predictor of Returns for Large Cap US Equity ETFs?

In 2010, Morningstar published a study which argued that expense ratios are "the most dependable predictor of performance" for mutual funds.1; This study included roughly 5 years of mutual fund performance data, based upon which the authors recommended that investors focus on the cheapest 40% of mutual funds as a starting point in the due diligence process.  While some have sought to apply similar heuristics to ETFs, the evidence presented below pertaining to US large cap equity ETFs calls into question the sensibility of this application.  Over the past 5 years (as of 2/29/16), the cheapest large cap US equity ETFs have tended to underperform ETFs with higher expense ratios, with significantly fewer funds producing excess returns versus their respective S&P benchmarks.2

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┬╣"How Expense Ratios and Star Ratings Predict Success", Morningstar, 8/9/2010.
┬▓Data obtained from Morningstar Direct. Including all ETFs from Large Cap Blend, Large Cap Value, and Large Cap Growth categories, with at least 5 years of performance history on 2/29/16 (80 ETFs).  This necessarily excludes ETFs that existed on 2/28/11, but have since become obsolete (23 ETFs).  While many of these ETFs would have been included in group #3, poor performance does not appear to be the primary cause of their obsolescence, in our opinion.  For the ETFs that would have been included in group #3 that accumulated at least 2 years of operating history (14 of 19 ETFs), 2 of 3 (67%) large cap value ETFs outperformed the S&P 500 Value Index in the 2 years prior to closing, 3 of 5 (60%) large cap growth ETFs outperformed the S&P 500 Growth Index in the 2 years prior to closing, and 1 of 6 (16.7%) outperformed the S&P 500 Index in the 2 years prior to closing.

Posted on Thursday, March 17, 2016 @ 2:48 PM

These posts were prepared by First Trust Advisors L.P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.