1. Unfortunately the research report did not look at % of cheap funds that outperform expensive funds (or % of 5-star funds that outperform 1-star funds). However, they did look at % of funds that survived and outperformed all their peers, calling it the success ratio. Not exactly the question you had in mind, but fairly close.

Expense ratios did better than ratings in predicting both the success ratio of the top bucket of funds (lowest expense and 5-star rating respectively) and the difference in the success ratio between the top and bottom buckets (lowest vs highest expense and 5- vs 1-star ratings).

The linked research report goes into far more detail regarding the different criteria they used to compare the predictive power of expense ratios and star ratings.

2. Fortunately, the research did look at average performance of the top vs bottom buckets. In 65% of the categories, a 5-star rating predicted higher average returns than 1-star ratings. Pretty good, except that lowest-expense ratios predicted higher average returns than highest-expense ratios in 100% of the categories.

Luke (#15),

I definitely agree that expense ratios are not the one and only criteria you should look at. There are many other factors you could consider, future viability of the fund company being one example. However, I believe most investors put far too much weight on historical performance. Remember that Morningstar ratings consider returns going back 10 years, and they still fail to match the predictive power of expense ratios.

I also consider things such as the TER, the age of the fund and how it has performed historically.

Again, I don’t assume future performance to be the same as past, but isn’t it logical to have more faith in a fund that has produced decent returns for 20 years than a brand new one that hasn’t yet proven the management skills of the fund managers?

The author has applied a comparison of the averages of two sample sets (performance of the cheapest and most-expensive quintiles), to the particular results of Morningstar ratings (65% results outperform).

Instead, analysis should be applied to either of two questions:

1. How many funds (%) in the cheapest quintile outperform funds in the most-expensive quintile?
2. Does the average performance of five-star rated funds out-perform, ON AVERAGE, the average performance of one-star rated funds?

@Luke (#6)

“I tend to try and pick the funds that meet my investing style (large funds, growth, fairly agressive) and are also performing well vs. their sector/peers.”

Although investing style/asset class is important to use, relative performance is essentially what Morningstar uses in its ratings. You should be careful about using recent performance in your evaluation.

It’s expense ratio is just 0.05%

Anyway I shifted most of my 401(k) funds into it

I can’t say I’ve ever cared what Morningstar or any other ratings company said about any funds I’ve owned. I use the expense ratio as a first criteria whether to consider a fund or not. Looks like I’m on the right track.

As a new investor, it’s always useful to have a few pointers when it comes to fund performance. Still, I’ve always taken ‘star’ ratings/letter ratings etc. with a pinch of salt.

While past performance is no indication of future gains etc. etc. I tend to try and pick the funds that meet my investing style (large funds, growth, fairly agressive) and are also performing well vs. their sector/peers.

Still, it’s a minefield for regular investors who don’t have a financial background!

Like Mr. Choi I am also na financial advisor who uses a version of Morningstar’s online software geared to financial advisors. I don’t frankly even look at the star rankings. Morningstar is a great provider of data for mutual funds, ETFs, Closed-end funds, stocks, etc. To me this is the value in their service and why I’ve used Morningstar since I started in the business in the mid 90s. I think the star system is used by many fund companies to promote their funds which is terribly misleading to the investing public.

Elysia– If Ing isn’t your only retirement option, I’d look around for other ones. At least with our plan they’re taking a full .7% off the top of whatever the original expenses are. On top of that, their index funds are very expensive AND they try to push you into even more expensive non-index funds. You might be lucky and able to buy Vanguard funds within your Ing account, but apparently I wasn’t. Anyway, I switched to Fidelity and was all good (well, except that Ing keeps “losing” my forms giving permission to transfer my old account). If Vanguard is an option, go with that and buy a target-date fund like recommended in Edwin Choi’s fantastic (everybody-should-read) previous article on target-date funds. Basically Ing is able to get a lot of money giving people who don’t want to think about this stuff bad advice, whereas the other companies make you do your own investing.

Another thing you can do is go to the bogglehead forums and ask for help. They seem to know everything about everything there and are willing to walk you through things. (I didn’t ask, but I found threads where people had been in my situation.)