Excerpted from Common Sense on Mutual Funds by John C. Bogle, pages 151-152

What happens when we begin to evaluate equity funds on the basis of their investment styles, as measured by their Morningstar categories? I'm now going to attempt to answer this question, using returns and standard deviations of return during the five-year period from 1992 through 1996. The first example is the large-capitalization blend group - mutual funds that invest in giant companies that have both value and growth characteristics. Of the 741 funds analyzed by Morningstar, this category has 211 - more than twice as many as any other group - and represents some 40 percent of the assets of all domestic equity funds (450 billion of $1.2 trillion of equity assets in the Morningstar database at year-end 1996). It provides a solid platform on which to begin the analysis.

Table 6.1 shows the returns and risks for the large-cap blend group. The funds are ranked in four quartiles, based on total returns for the period. Even though returns rise, risk in this category remains virtually unchanged, and standard deviation remains remarkably constant over the quartiles. The risk-adjusted return ratio increases by the same magnitude as the total return, from a ratio of 0.74 to 1.37 - fully 63 ratio points from the lowest to the highest, an astonishing 85 percent difference. And, this outcome for the large-cap blend (middle-of-the-road) fund category seems to be typical. Seven of the nine categories (the exceptions are small-cap value and medium-cap growth) have fairly steady risk scores, whether returns are high or low. Hence, the top risk-adjusted ratings were consistently earned by the funds with the highest total returns.

But if risk does not account for these differences in return, what does? Is it manager skill, or luck, or something more tangible? One thing that is tangible is fund expenses. And it is one element of fund performance that has a powerful tendency to remain fairly persistent in a given fund.

So, I divided the funds into cost quartiles. The funds with the lowest expense ratios constituted the first quartile, and the funds with the highest ratios were placed in the fourth quartile. It will come as no surprise to anyone who has seriously studied investment returns - either on a theoretical academic basis or from pragmatic experience - that cost matters. In fact, the funds in the group with the lowest expense ratios had the highest net returns. At the same time, they assumed a nearly identical level of risk (volatility), and therefore provided distinctly higher risk-adjusted returns. The data presented in Table 6.1 are arrayed according to expense quartiles in Table 6.2.

We are now onto something important. With risk astonishingly constant, high returns are directly associated with low costs. In the large-cap blend group, the average risk-adjusted rating provided by the lowest-expense funds (1.23) is 24 percent higher than the 0.99 average rating for the highest expense funds. Expenses are clearly a compelling factor.