Fund fees and performance: the link is getting stronger
- Robin Powell
- 2 hours ago
- 9 min read
New research from Morningstar confirms that fund fees and performance are more tightly linked than ever. The "skill" component that once helped expensive funds justify their costs has all but disappeared.
You know that feeling when you find a cheaper flight? Same destination, same airline, maybe even better seats. You check the price three times because it seems too good to be true. Then you book it, and for a brief moment, the world makes sense.
In most areas of life, we understand instinctively that paying more doesn't guarantee quality. The £15 bottle of wine often tastes as good as the £40 one. The budget airline gets you there as fast. The supermarket own-brand paracetamol is chemically identical to the branded version.
Yet millions of investors still believe that expensive funds must be better. That higher fees signal superior expertise. That you get what you pay for.
The fund industry has spent decades cultivating this myth. And for years, they had enough cover to maintain it. Some expensive funds did beat their benchmarks. Some star managers did deliver. Not many, and not consistently, but enough to keep the dream alive.
Research from 2016 showed that only 21% of the most expensive international equity funds survived and outperformed their peers. Cheap funds more than doubled that success rate. But even then, defenders of active management could point to the exceptions. The Terry Smiths of the world. The managers who seemed to possess genuine skill.
That defence is crumbling. And the latest evidence suggests it may collapse entirely.
The most reliable predictor we have
Fund fees predict future performance better than anything else we can measure. Not past returns. Not star ratings. Not the manager's CV or the fund's investment process. Fees.
In 2016, Russel Kinnel, then director of mutual fund research at Morningstar, published a study testing every variable available against funds' subsequent returns. The winner wasn't close.
"Fund fees are a strong and dependable predictor of future success," Kinnel concluded.
His methodology was clever. Rather than tracking returns alone, he measured what he called "success ratios": the percentage of funds that both survived and outperformed their peers. This matters because fund companies routinely kill off their failures. Looking only at survivors flatters the industry. Kinnel's approach captured the full picture, corpses and all.
The results were stark. Among international equity funds, 51% of the cheapest quintile succeeded. Only 21% of the most expensive did. Balanced funds showed a similar gap: 54% versus 24%. Taxable bonds: 59% versus 17%. The pattern held everywhere Kinnel looked.
And it held every time. He ran the analysis across multiple time periods. Cheap funds won in all of them.
This wasn't a marginal finding or a statistical quirk. It was the closest thing investing has to a law of nature. Pay less, keep more.
But Kinnel's study left one question open. Were cheap funds winning purely because of lower costs? Or were expensive funds also losing on the "skill" side, generating worse returns even before fees?
That question now has an answer.
Fund fees and performance: the link is stronger than ever
Jeffrey Ptak, Morningstar's chief ratings officer, has taken the analysis further. His research, published on his personal Substack in December 2025, confirms Kinnel's findings and extends them uncomfortably for anyone still paying active fees.
Ptak ranked stock and bond funds by their expense ratios and sorted them into five buckets: the cheapest 10%, the next 22.5%, the middle 35%, the next 22.5%, and the priciest 10%. He then tracked their performance over the decade to November 2025.
The results formed an almost perfect staircase.
Cheapest funds delivered the highest returns. Second-cheapest came second. And so on, all the way down to the most expensive funds at the bottom. No exceptions. No surprises. The quiet, relentless mathematics of compounding costs.
But here's where it gets interesting.
Ptak wanted to know how much of the cheap funds' advantage came from fee savings versus differences in pre-fee returns. Were expensive fund managers at least generating better gross performance to partially offset their higher costs? Or were they losing on both fronts?
To find out, he decomposed the rolling 36-month return gap between the cheapest and priciest funds into two components. The fee difference. And whatever was left over.
Over the past decade, the fee difference explained nearly all of the outperformance. The "whatever was left over" component, the part you might generously call skill, had shrunk to almost nothing.
Expensive funds weren't losing only because of their costs. They weren't generating any meaningful advantage before costs either. The whole premise of paying more for better management had collapsed.
Ptak put it simply: "Investors choosing funds should start with fees."
A decade ago, skill still mattered (just)
This wasn't always the case. Ptak ran the same decomposition analysis for the previous decade, from December 2005 to November 2015. The picture looked different.
See all that blue? That's the pre-fee return difference, the portion of the performance gap that wasn't explained by fees alone. Call it skill, call it luck, call it market conditions favouring certain styles. Whatever it was, it existed. Expensive funds were still losing overall, but some were generating enough alpha to partially offset their cost disadvantage.
Now look at the most recent decade.
The blue has almost vanished. What remains is overwhelmingly red: the fee difference, pure and simple.
The contrast tells the story better than any statistic. In the earlier period, you could squint at the data and make a case for active management. Sure, cheap funds won on average, but the best expensive funds were doing something. They were generating real pre-fee outperformance that, for investors lucky enough to pick the right ones, might have justified the higher costs.
That fig leaf is gone.
Think of it like a casino. The house always has an edge; that's how casinos make money. But a decade ago, some players were skilled enough to occasionally beat the odds. Card counters. Poker professionals. People who'd figured out an angle.
Today? The edge has become insurmountable. The game got harder, the competition got fiercer, and whatever angles once existed have been closed off. The house takes its cut, and almost nobody beats it anymore.
Ptak hints he has a theory about what's driving this change. But whatever the cause, the implications for investors are clear.
The game changed, and active managers lost
Why has the skill component disappeared? Several forces have converged, and none favour stock pickers.
Markets have become brutally efficient. Information that once took days to spread now travels in milliseconds. The analyst who spots an undervalued company finds herself competing against algorithms, quant funds, and thousands of other analysts who spotted the same thing. Whatever edge a manager might have discovered in 2005 has long since been arbitraged away.
The weak have been culled. Decades of underperformance have killed off the worst active funds. Merged, liquidated, quietly swept under the rug. The survivors are more competent than the casualties. But that's the problem: when everyone left standing is reasonably good, nobody has an edge over anyone else. They're all fighting for scraps of alpha that barely exist.
Closet indexing hasn't gone away. Plenty of "active" funds still hug their benchmarks so closely that they're effectively expensive trackers. They charge active fees for passive portfolios. They can't beat the index because they basically are the index, minus their costs.
And the gap keeps widening. As passive fund fees have fallen toward zero (some global ETFs now charge 0.07%), the relative handicap of expensive active funds has grown even larger. A 1% fee looked more defensible when index funds charged 0.5%. It looks absurd when the alternative costs almost nothing.
None of these trends are reversing. Information will keep spreading faster. Competition will keep intensifying. Passive fees will keep falling.
The casino hasn't changed its rules. But the game has got harder, the other players have got better, and the cost of sitting at the table has become impossible to justify.
So what about the managers who seem to defy all this?
What about Terry Smith?
There's always an exception. Or so the argument goes.
Terry Smith launched Fundsmith Equity in November 2010 and built it into the UK's largest fund. His track record over the first decade was extraordinary. His philosophy is simple: buy good companies, don't overpay, do nothing. It resonated with investors tired of frenetic trading and opaque strategies. He became the closest thing British investing has to a celebrity manager.
Surely someone like Smith proves that skill exists?
Maybe. But past skill isn't the issue. The question is whether Smith will generate enough alpha going forward to overcome a guaranteed annual drag. And that drag is substantial.
Fundsmith Equity charges an ongoing fee of 1.04%. By way of comparison, the Amundi Prime All Country World ETF, for example, charges 0.07%. That's a difference of 97 basis points every year, regardless of what markets do or how Smith performs.
The maths is unforgiving. Start with £100,000, assume identical 7% gross returns, and let compounding do its work. After 20 years, the fee gap costs you roughly £64,000. After 30 years, you're £178,000 worse off with Fundsmith.
Smith would need to beat the global index by nearly a full percentage point annually, for decades, to break even with the cheap alternative. Ptak's research suggests that's becoming almost impossible for any manager to achieve consistently.
And there's another problem. Even if Smith does outperform over the long term, will you capture it? Fundsmith has now underperformed for four consecutive years. Billions have flowed out as investors lost patience. How many bought high and sold low, locking in the worst of both worlds?
The star manager defence assumes you'll pick the right one and stick with them through the bad years. History suggests most people do neither.
The simplest decision you'll make
Choosing cheap funds isn't a sophisticated strategy. It's barely even a decision. You're refusing to pay more for something that's statistically unlikely to be better.
Start with fees when selecting any fund. Filter by cost first, then worry about everything else. Kinnel's research established this principle. Ptak's confirms it holds stronger than ever.
Favour index funds and low-cost ETFs. The fee advantage has become virtually the only reliable predictor of future performance. A global tracker charging 0.07% gives you the market return minus almost nothing. An active fund charging 1% needs to beat the market by 1% to match that. Most can't. Most won't.
Be sceptical of performance claims. Past returns tell you almost nothing about what comes next. We've known this for decades, yet fund companies still plaster three-year track records across their marketing. Ignore them. The one number that reliably predicts the future is the one they'd rather you didn't focus on.
Consider your total costs. Fund fees aren't the only drag. Platform charges, trading costs, and adviser fees all compound alongside your investments. Get the full picture before you commit.
None of this requires special knowledge or sophisticated analysis. You don't need to identify the next great manager or time your entry perfectly. You need to stop paying for something that doesn't exist.
Remember that cheaper flight? Same destination, same airline, maybe better seats. You didn't hesitate. You booked it.
Investing should feel the same way. For years, the fund industry convinced people that paying more meant getting more. That expertise commanded a premium. That somewhere out there, a brilliant manager was worth every basis point.
The evidence never supported this. But there was enough noise in the data, enough star managers having good decades, that the myth survived. You could believe if you wanted to.
That's getting harder. Ptak's research shows the gap between belief and reality has widened into a chasm. Whatever skill component once existed has essentially vanished. Fees don't predict performance; they've become almost the whole story.
The good news is this makes your job easier. You don't need to find the next Terry Smith or time your exit from a fading star. You don't need to analyse holdings, study manager track records, or decode investment processes. You need to pay less.
The fund industry built its business on the idea that skilled managers could beat the market's house edge. The latest evidence suggests they can't. The house always wins.
But here's the thing about investing: you don't have to play their game. Low-cost index funds let you own the house instead.
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