From The Motley Fool
Enter Index Funds
Past Performance
The 5 criteria you should know
It's crunch time!
The good, the bad and the ugly
We're not mind readers, but our guess is that you clicked here looking for answers to two main questions:
Q: Which ones should I pick?
Without mincing words, here are our answers:A: Some are. And, A: The ones that consistently outperform all the others.
We're not trying to be cheeky. (OK, you caught us, we are.) It's just that the world of mutual fund performance is more complex than any 14-syllable answer that we could offer. There are thousands of mutual funds from which to choose. And there's no shortage of bold-faced statements touting them. Advertisements in newspapers flaunt a fund's "five-star" status. Banner ads brag about "the NUMBER ONE FUND in America" while commercials hype "top returns over the last six months."
It seems there are thousands of funds out there that have done really, really well. Just choose one, already!
What? You want more than seven words in bold type on a blinking banner to make sure you're making the right investment?
Good for you. The sad fact is that the vast majority of mutual funds underperform the average return of the stock market. Some simply pick bad stocks. Others pick stocks fairly well, but not well enough to compensate for the costs of the fund. Remember, fund shareholders have to reduce their returns by whatever costs are imposed by their funds.
In addition to fees, there are four other pitfalls mutual fund investors have to watch out for:
- Dubious management. Given how many funds there are, not everyone can be above average. Many mutual fund managers have proven no better at picking stocks than the average nonprofessional, but charge fees as though they are.
- No control. Unlike picking your own individual stocks, a mutual fund puts you in the passenger seat of somebody else's car.
- Dilution. When mutual funds own too many holdings, even insanely great performance by their best ideas gets watered down when you look at their overall performance.
- Buried costs. Many mutual funds specialize in burying their costs and in hiring salespeople who do not make those costs clear to their clients.
You Can Beat the Market
Since most funds' fees leave them underperforming the market indexes, the key is to find a fund that at least matches the market and has minimal fees. There is an easy way to do just that. You need only buy a passively managed fund that tracks the index and charges super-low fees. Enter index funds. On the whole, index funds have lower expenses and are more tax-advantaged because their holdings don't turn over as much.
But if you've got an itch to shoot for higher returns than index funds offer, or don't have access to an index fund in, say, your 401(k), there are some funds -- or, more precisely, some fund managers -- whose services are worth paying for, because they are superior investors who are simultaneously fee-conscious.
To find out which funds are worth owning, let's put your mutual funds through the paces to help you spot the gems and dump any losers you might own. In particular, you'll want to look at:
- Assessing the costs of a mutual fund, taking all fees into account.
- Measuring the after-fee returns of mutual funds.
- Defining a superior fund in qualitative and quantitative terms, so you'll know when you've found one.
Narrow Down the Field
Although past performance is certainly not an indication of future results, there are some clues to be found about the quality of a fund by correctly measuring its past performance.
Morningstar, a company that specializes in mutual fund analysis, provides helpful tools to compare funds. One is the fund selector, which allows you to retrieve the top-performing funds in various classes. You can, for example, search for all the domestic stock funds that invest in financial companies and rank them by performance. That will tell you how your fund measures up against its direct competition in raw performance. You can also measure how it has done in relation to various market indexes (like the Standard & Poor's 500).
After you've looked at how a fund stacks up against its peers and the S&P, you just buy the one that comes out on top, right? Wrong. You've only taken the first step to discovering how your mutual fund has performed, because stated returns don't include all the fees that you will pay or predict future success. Two funds may have the same reported return, but they may not have returned the same rate to investors.
Why? Funds can charge fees beyond those required to operate them because most people don't pay any attention to them.
Ferret out the fees
In addition to the process of assessing risks and estimating future returns or prospects common to any investment, with mutual funds you must also evaluate and compare costs between funds. The trick is to decide which fund(s) will give you the biggest bang for your investment dollar within your risk class.
The trouble is that it's hard to know exactly how much you're paying, since funds don't put the fees all in one place. You have to piece together a variety of expenses to find out how much you are paying for the service. Of course, it's not that hard if you know what you're looking for and where to look.
Where to look
- All fees appear in the fund's prospectus.
- You can also find fees in the "Fees and Expenses" portion of a fund'sMorningstar profile.
Sure, most people never read those things. But that's why so few people find the truly great mutual funds that are out there.
Intro to Evaluating Managed Funds
Looking for a sound philosophy, a proven investment record, decent tenure, low turnover, and low expenses are the key elements to use as screens to find a quality managed fund. Bonus points should be awarded to any manager who "eats his own cooking" by investing his money along with yours in the fund, although such information will be hard to determine without talking to the manager directly.
Remember: Outstanding fund managers are outliers by definition. Here's how one actual fund manager put it: "As far as conventional thinking is concerned, it produces conventional results." Thus, a good fund manager's portfolios will need to look quite a bit different than an index fund's holdings in order to have a chance at outperforming it over time. Keep that thought in mind if you ultimately decide to go with a managed mutual fund instead of an index fund.
You should start by narrowing down the field by only looking closely at funds that have the following:
- high performance
- turnover no higher than 50%
- expense ratio below 1.75%
- no loads
If your fund passes this test, it's time to dig deeper. Take a look at our series onpicking the right mutual fund to help you measure a mutual fund's worthiness.
NOTE: If you have a mutual fund already, the odds are good that it does not meet all our criteria. That does not mean that you should sell immediately. We cover that elsewhere.
It's important to be aware not only of expenses and performance, but also the quality of the managers. In the end, your returns from a fund come from the manager's ability to allocate profitably the assets under his charge.
Hands-On Analysis
We've helped you narrow down the field to the seven essential things you need to look for in a mutual fund. A quick recap -- look for funds that have:
- No loads
- Turnover of no higher than 50%
- Expense ratio below 1.75%
- A manager with a proven track record of outperforming the S&P 500
- A manager with a sound investment philosophy
- A manager with a long tenure
- A manager with a sound investment philosophy
So how do you get at this information? It's easier than you think. Here are some ways to get started:
- If you haven't read through our series on picking the right mutual fund yet, do it now. You'll find plenty of ideas on going about evaluating funds you like.
- Take advantage of our Motley Fool Champion Funds newsletter service to learn more about what makes a great fund. Our fund experts do a lot of your work for you, going through thousands of funds to find ones with the best potential for profits.