What Makes A Good Mutual Fund?
June 25, 2015That’s a common question I get in our investing workshops. Most people instinctively look at performance. After all, that’s how we typically measure ability and try to predict future performance in most areas but investing is different.
First of all, a lot of mutual fund performance is based on what type of investment happens to be doing well in any given time period. For example, technology funds were doing dominating in the late 90s during the dot-com bubble and then real estate soared during the real estate bubble but neither type of fund outperformed afterwards. The last thing you want to do is buy a fund near the peak of its cycle and then sell it after it eventually loses value. You end up buying high and selling low, which is the opposite of what you want to do.
But even when you compare funds that invest in the same type of investment, past performance is not a good indicator of future performance. Standard and Poor’s releases reports twice a year showing that mutual funds with strong past performance relative to their category are unlikely to repeat that performance in the future. In fact, you would have been better off picking funds randomly in many cases.
Why is that? One reason is that a successful fund attracts more money and the more money the fund has, the harder it generally is to manage. Managers also change. The manager that built that great track record may no longer be managing the fund. Finally, there’s also a lot of luck driving those returns and many economists would even say that all out-performance is luck.
So what should you look for? Here are three of the main things:
1) What does the fund invest in? In order to be properly diversified, you’ll probably want funds that represent many different types of investments. It doesn’t matter how good the cereal is when you’re shopping for milk.
2) Is the fund true to its category? If you buy a fund that invests in small company stocks, you don’t want it owning large company stocks too. This is called “style drift” and can cause you to end up with too little in small company stocks and too much in large company stocks.
3) How expensive is the fund? If you want to invest in small company stocks, you’ll want to do so as cheaply as possible since fees eat into your returns. In fact, Morningstar even had to admit that low fund expense ratios (the fees that funds charge every year) is a better indicator of superior future performance than their own star rating system. In addition to low expense ratios, you might also want to look for funds with low turnover since more turnover can mean higher transaction costs that also come out of your pocket.
Keep in mind that there is no such thing as a perfect mutual fund. Funds that meet all these criteria can and probably will lose value from time to time. All I can tell you is that they should give you the best chance of maximizing your returns for your chosen level of risk. When it comes to investing, that’s about as good as it gets.