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.
