Excerpted from Common Sense on Mutual Funds by John C. Bogle, pages 91-93

From much that I hear, I am known as a sort of fringe fanatic - an apostle of the message that costs play a crucial role in shaping long-term fund returns. I've said Cost matters for so long that one of my followers gave me a Plexiglas pillar inscribed with the Latin translation: Pretium Refert. But cost does matter. I've shown you the effect on returns and on asset allocation. I've been harping about costs for years, and it was with some delight that I read these words from Warren Buffett in the Berkshire-Hathaway Annual Report for 1996:

Seriously, costs matter. For example, equity mutual funds incur corporate expenses - largely payments to the funds' managers - that average about 100 basis points, a levy likely to cut the returns their investors earn by 10 percent or more over time.

Sadly, Mr. Buffett was too conservative in his calculations. The average equity fund now charges not 100, but 155 basis points, and also incurs portfolio transaction costs of at least another 50 basis points. Together, they comprise expenses of 200 basis points or more. If I may revise his comment, then, fund costs are a "levy likely to cut the returns their investors earn by 20 percent or more over time." Again, sadly - and unbelievably - bond fund fees also average more than 1 percent, a grossly unjustified levy on any gross interest yield, especially today's nominal yield of about 5-1/4 percent on the long U.S. Treasury bond, which would be cut by almost 20 percent. I regard such costs as unacceptable.

A low expense ratio is the single most important reason why a fund does well. Therefore, carefully consider the role of expense ratios in shaping fund returns. If you select actively managed funds, emulate the index advantage by choosing low-cost funds. The surest route to top-quartile returns in bottom-quartile expenses. Using yet another period - the five years from 1991 to 1996 (detailed figures are given in Chapter 6) - Table 4.1 gives the record for funds owning stocks with large market capitalizations.

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Note that both groups earned similar preexpense returns. But the 1.2 percent cost advantage was largely responsible for the 1.90 percent performance advantage for the low-cost funds. The link is hardly accidental. Lower costs are the handmaiden of higher returns.

The costs that actively managed funds incur in buying and selling portfolio securities are hidden, but nonetheless real. Fund portfolio turnover averages some 80 percent annually. It is expensive, perhaps adding as much as 0.5 to 1.0 percentage points (or more) to the more visible cost of fund expenses. So, favor low-turnover funds, but not only because these costs are lower. They also provide substantial tax advantages. The longer that actively managed funds hold portfolio securities, the greater the extraordinary value of deferral of capital gains becomes to their shareholders. Many high-turnover funds are expensive as well as tax-inefficient, so it behooves you to consider after-tax returns, along with present unrealized gains, which could lead to potentially massive future capital gains distributions and the burden of unnecessary taxes. The odds against active managers' outpacing the after-tax returns of index funds rise even higher. So if you own any funds outside of a tax-deferred retirement plan, don't forget that taxes are costs too.

Enough said, except that I would like to justify not only my appraisal of the importance of low-cost funds as a guideline for selecting funds, but also my selection of this warning as Rule 1. I rely on the support of William F. Sharpe, Nobel Laureate in Economics, who in a recent interview said: "The first thing to look at is the expense ratio" (italics added). You should follow his advice and recognize that selecting among low-cost managed funds should maximize the unlikely possibility that you will earn returns in excess of a low-cost index fund (20 basis points or less) simply because minimizing the cost differential gives a fund a far greater chance to compete successfully. After all, a low-cost fund with a 40-basis point expense is fighting a 20-knot breeze in its efforts to win the sailing race, but a high-cost fund (150 basis points) is fighting a 130-knot typhoon.