Is everything you need to know about mutual fund investing contained on this napkin? 

This sketch by Carl Richards originally appeared in The New York Times. More of his sketches can be found at Behaviorgap.com.

Probably not. But a recent Morningstar study suggests that keeping this bit of folded wisdom in your pocket might be more helpful than consulting an army of experts in the search for clever money managers.

Morningstar examined five broad categories of equity and fixed-income funds over multiple periods beginning in 2005, 2006, 2007 and 2008 and ending in March 2010. Funds were sorted into quintiles based on expenses and the performance of the cheapest funds was compared to that of the most expensive. They computed total return for funds surviving through March 2010 as well as a "success ratio" measuring the percentage of the initial cohort that went on to survive and outperform their peers.

Unsurprisingly, cheap funds outperformed their expensive cousins. Commenting on the results, Morningstar Director of Mutual Fund Research Russel Kinnel observed: "In every single time period and data point tested, low-cost funds beat high-cost funds."¹

A similar exercise evaluated the same funds using the Morningstar Ratings assigned at the beginning of each time period. The ratings showed predictive power as well, although not as pronounced as the expenses ratios. "In general," Kinel states, "5-star mutual funds beat 1-star funds on our three measures, although there were exceptions. All told, the stars guided investors to better results in 59 out of 70 (84%) observations."

So which measure is more useful for investors—fund expenses or ratings? Morningstar declines to crown a champion, finding merit in both. Expenses were a more reliable predictor ("they worked every time"), while stars could be helpful "In identifying funds that might be merged out of existence."

For reasons unclear to us, the predictive power of expenses in this exercise was more pronounced among equity funds than fixed income or balanced vehicles. Among both domestic and international equity funds, total returns in every time period were higher for the cheapest funds compared to the 5-star funds.

Morningstar concludes that "Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance."

Sounds good to us.

Waiter, I’ll keep that napkin.

1. Russel Kinnel. "Fund Spy—How Fund Expense Ratios and Star Ratings Predict Success" Morningstar, August 9, 2010