Imagine that you have decided to invest in a stock mutual fund. Given the tear the American market has been on lately, you decide to invest in a fund that exclusively buys U.S. stocks. Also, because you’ve heard some good things about index funds, you decide to buy a fund that tracks the investment results of the S&P 500 index and owns 500 leading, large companies in the U.S. Fortunately, you have some choice because more than one investment company offers this type of index fund.

So looking at the chart below, which fund would you pick?

The one you should have picked is the JRN Index Fund. Why? For the simple reason that it has the lowest management expense ratio (MER). Remember, each of these funds is designed to replicate the returns of the same S&P 500 Index, so they should perform virtually identically before fees and costs. So the only variable that should have any real impact is the MER.

But what about those differences in annual returns?  They vary solely because the dates used to measure “annual returns since inception” depend on when the fund was launched. So the JRN fund, despite being the cheapest, appears to have lagged in performance simply because it was launched in the technology boom of the late 1990’s when the U.S. market was pricey and the Canadian dollar was in the doldrums.

If you picked the CWD Index Fund because it has the highest return, notwithstanding that it also has the highest MER, don’t despair. You’re in good company. In an experimental study conducted by Professors Choi, Laibson and Madrian, 391 members of the Harvard University staff were asked to invest a hypothetical $10,000 across four S&P 500 index funds with varying returns since inception and MER’s. Some 38% of the money invested was erroneously allocated to the most expensive fund simply because it had the highest return since inception.

The professors conducted the same experiment with two study groups comprised of college students from Harvard University and MBA students from the Wharton School of the University of Pennsylvania, considered to have one of the top finance programs in the world.  In each of these elite groups, less than 20% of the $10,000 was allocated to the cheapest S&P 500 index fund. Overwhelmingly, study participants placed a high emphasis on returns since inception and failed to minimize fees even in the face of the commodity-like nature of an index fund. If finance geeks don’t get it right, what hope does the average investor have?

Unfortunately, investors’ intractable infatuation with fund returns leaves them chasing false signals far beyond the realm of index funds.  A host of studies has found that the performance of actively managed funds is rarely persistent.  It’s a roll of the dice whether the top ranked funds of today will outperform tomorrow. Yet, regardless of asset class, country or time period, investors place a disproportionate amount of their investment dollars with the funds sporting strong recent returns.

By using returns to pick their funds, investors ignore the single best predictor of a fund’s long-term performance — its management expense ratio.  Numerous academic studies have found that, in general, low-cost mutual funds outperform high cost mutual funds.  Morningstar found that expense ratios are an even better predictor of performance than their famous fund rating system and had to conclude that “investors should make fund expenses a primary test in fund selection.”

In addition to embellishing mutual fund ads with the generally ignored caveat “past performance is no guarantee of future results,” investors would be well served by a further note to the effect that — “low management expense ratios are associated with better future performance.”

Michael Nairne is the president of Tacita Capital Inc. a private family office and investment counselling firm in Toronto. Visit tacitacapital.com .