There are plenty of poor mutual funds. Investors are a captive audience for fund companies that prey on restricted 401(k) and 403(b) plans. When mutual funds never fear the possibility of losing assets under management, quality can suffer.
But there are many great mutual funds out there too. Spotting these quality funds and separating them from lesser-quality funds can be done in only a few minutes of research.
Here’s what you need to look for before buying into any actively-managed mutual fund:
- Category – The fund category (small, medium, or large cap stocks) says a lot about the potential for a fund to outperform the market. Keep in mind that it is much easier for smaller funds to produce outsized returns in the small and medium cap corners of the stock market than it is for a large fund to do the same in large cap stocks. A manager can add a lot more value in less watched small cap stocks than he or she can in large cap stocks.
- Turnover – Funds with less asset turnover will produce better results in the long-run. Remember that mutual funds have an unbelievably large amount of money to move around and usually have to add or subtract capital from a position in a maneuver that may take several days or week to complete. Over the course of days and weeks, large funds can easily push up or down the price of an individual stock, dragging down the fund’s performance.
- Cash position – Don’t be a fool for fund marketing. Many actively-managed funds have created “aggressive,” “moderate,” and “conservative” funds that hold cash in varying levels to meet investors’ risk tolerance. Some “conservative” funds hold as much as 50% of all invested capital in US Government T-bills that mature in days and even weeks. Such investments earn less than .2% per year for investors at a cost of 1-2% in fund management fees. Don’t pay money for an asset manager to keep your money in cash – the bank would be a better place to store your cash.
- Strategy – It’s common to see that the best performing funds in their class have very lenient strategies where virtually nothing is “set in stone.” When asset managers are confined to a very simple strategy or asset allocation, there really isn’t much wiggle room for someone to add value to the fund. However, when asset managers have free reign to chase the securities they find most interesting – whether they chase stocks, bonds, preferred shares, or complicated hedges – they can add more to a fund’s performance.
- Track record – While past performance never guarantees future results, past history does mean something. I like to see funds with a long history of good management, and love the small-time family funds that frequently appear atop long-run performance charts. Long-lived management teams are no longer in the business for money anymore; they’re in it because they enjoy it. Otherwise, a few years of stellar performance would have sent them packing for a retirement in the Hamptons.
- Fees – Fees are important but only in the sense that it is harder for a high-fee fund to outperform the broad market than a lower-fee fund. At the end of the day, though, fees are relative – I think most anyone would pay a 5% annual management fees for 30% annual returns. All funds must be compared on performance after fees and expenses.
Do you own any active funds? What sold you on the funds that you own?