While doing a bit of research on choosing mutual funds, I found that almost all the blog posts and web pages seem to suggest how harmful the expense ratio is, how much money we lose over time due to the expense ratio, etc. That naturally makes an investor feel to choose funds with a lower expense ratio. However, it is also my understanding that the NAVs reported by mutual funds already makes necessary adjustment for the expense ratio, so that the 1/3/5 year returns typically reported by the fund research tools are the ones realized after the deduction of the expense ratio. In other words, we do not need to account for the expense ratio ourselves while shopping for funds. Lowering the expense ratio, according to my understanding, only matters when we have another fund with a similar distribution of holdings, and has a lower expense ratio which yields a higher return. My question is, should we really be looking at the expense ratio while choosing funds as far as the rate of return is concerned?
Past performance accounts for the expense ratio, but is (proverbially) not indicative of future results. In particular, going by past performance and choosing a fund that has recently beaten the market will, according to the efficient market hypothesis (EMH), give no greater chance of beating the market in the future. In fact, it may incur excessive risk.
The expense ratio is one thing that really is predictable -- it is a direct drag on your return and this predictability does not conflict with EMH. So, looking at the expense ratio separately is a way of distinguishing signal (a recurring effect on returns going forward) from noise (past performance fluctuations).
While the expense ratio is deducted from the NAV, it is still relevant. Imagine you have two index funds tracking the same index. One with 0.1% and the other with 1% TER. Obviously the cheaper fund will outperform the expensive one.
Now we add a layer of complexity and pick active funds. The expected return of a randomly chosen fund before costs is the market average. As high performing funds do not tend to keep their outperformance in the future, this is equal to choosing a well performing fund. Therefore expenses are the most significant predictor of your long term return after costs.
PS: you might no have the impression that funds perform average on average. Check for survivorship bias