Measuring things gives us a great deal of comfort. It makes our world tangible. Rulers, in particular, represent the ideal tool for this activity. They can tell how wide a cubicle is, how long a desk is, and how tall a person is.

Read: You know what they say about return assumptions

Think about those measurements for a moment, especially the last one.

If we’re hiring someone to act as a financial adviser, we want that person to be smart. Does it matter how tall he is? No.

Is it easier to measure height than intelligence? Yes. Just because it’s easier to measure something, however, doesn’t mean it’s relevant to the hiring decision.

Mutual fund expense ratios present a similar bind. Unfortunately, poor or lazy reporting in the mass media only exasperates the situation (see “Media Short-Cuts on Expense Ratios Can Misdirect 401k Fiduciary Due Diligence,” FiduciaryNews.com, March 8, 2016).

The problem is mutual fund expense ratios are just too darn easy to measure. They’ve become a benchmark to nowhere.

Worse, they led us down a path of statistical misdirection blurred by the mystique of a common sense logic this is plainly illogical.

Read: The time is nigh for the 401(k) MEP

Let’s dissect a few of these myths by way of example. First there’s the misstated axiom that you can’t get higher returns when a fund has a higher expense ratio. If this were an absolute rule, you’d never see a fund with a higher than average expense ratio producing above average performance.

Yet, for the 15-year period ending on 12/31/2014, the Morningstar Principia database shows more than two dozen funds in the large cap growth category alone that have dome this. Just because it’s easy to measure a fund's expense ratio doesn’t mean it can reliably predict fund performance.

There’s a second misstated axiom (that generally followed the first). It states that, because “low expense ratios are better,” investors should use only index funds because they have the lowest expense ratios.

If, however, we look at the same database cited above, we see evidence of a very different conclusion.

For the 15 years ending 12/31/2014, Morningstar has the average S&P 500 index fund earning about 3 percent per year. Non-index funds with the same objective (and with higher expense ratios) averaged roughly 5 percent per year over the same time period.

So, not only can higher expense ratio funds produce above average performance results, but the entire notion that index funds always outperformance there actively managed counterpart can be thrown out the window.

That’s an impressive one-two punch. It also shows why emphasizing a specific metric may not be relevant to making the best decision and may only reflect the relative ease of measuring that metric.

Shouldn’t it be time we admit the mutual fund expense ratio is a less than perfect metric and begin using a metric that makes more sense?

Instant Insights /

Are we afraid to admit mutual fund expense ratios are a bad metric?

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