You're a responsible investor, striking the appropriate balance between aggression and conservatism when deciding where to place your money. So, that means you do what the textbooks recommend, and you buy shares of a mutual fund; but the choices can be overwhelming.
The Investment Company Institute, a trade association for mutual fund companies, notes that there are over 7,000 active mutual funds in the United States at any given time. Each fund has a professional manager, if not a management team, which makes the prospect of finding the best available manager a daunting one. What criteria do you use? Pedigree? Education? Reputation? Of course, none of that is quite as important as results.
We've all seen the news stories about monkeys in the zoo that pick stocks as successfully as (at least some) professional fund managers do. The dirty little secret of investment management is that, unlike almost any other field of quantifiable endeavor, the same names don't necessarily predominate year in and year out. This year's big winner might not be next year's big loser, but there's no guarantee it'll stay on top, either. For instance, Morgan Stanley's Focus Growth Fund was among the best-performing mutual funds of 2010. It gained over 23% that year, or almost double what the S&P 500 did.
That comes with a qualification. Dividing one entity's gain by another's and coming up with a number close to 2 doesn't necessarily mean that the former performed twice as well as the latter. If we're looking at prices, rather than just the increases in those prices, we have to include the original levels, before conducting our comparison. The Focus Growth Fund finished the year at 126% of the level it started the year in question at, while the comparable number for the S&P is 113%. From that perspective, the Focus Growth Fund outpaced the S&P by a considerably more mundane 11%, which is superb if not exactly "double." However, you can imagine that the Focus Growth Fund's manager doesn't brag that the fund "beat the S&P 500 by 11 whole percentage points!" which falls into a category of boasting that some investment advisors are guilty of.
Nor would the manager mention that the fund fell 6% the subsequent year. That same year, the S&P went essentially unchanged. You have to go to the second place to the right of the decimal point to find any change in the index at all. The S&P fell .04 points in 2011, which means that using the same selective math as in the above example, the Focus Growth Fund did 1,600 times worse than the S&P over the year. Again, this is the kind of superlative that makes it into very few corporate biographies.
Every subpar performance by a mutual fund (and by extension, its manager) has a ready-made excuse. "If only this one particular sector had improved, our holdings would have beaten the market." "The December sell-off killed us, otherwise we'd have been right in the black." "Well, we had three years of abnormal growth, and were bound to crash back down to earth eventually: still, beating the market three out of four years is nothing to scoff at." It's only human nature for the funds' managers to accentuate the positive, while downplaying the negative.
There's a saying about another traditionally volatile investment, real estate: you make your money going in. To some extent, the same is true when selecting a mutual fund manager. While you have little control over what a mutual fund's year-over-year return is going to be, you have complete control over how much of your investment will go to its upkeep.
There isn't a fund manager alive who has enough faith in themselves that they're going to earn their living simply via stock appreciation. Instead, they each charge you a percentage up front: the fund's management expense ratio. The one constant for mutual fund investors, is knowing that they can subtract that ratio from their investment before calculating anything else. These ratios vary widely, so much so that some funds' expense ratios are 37 times the size of others.
That being said, there are perfectly valid reasons for one fund to charge 1.85% while another charges .05%. The former might invest in multiple countries, requiring it to hire employees across the globe. Generally speaking, a lower expense ratio means a more firmly entrenched, larger fund. (And thus a more conservative one. There exist funds with a disproportionate focus on penny stocks, but as you might imagine, those funds never grow large enough to be major players.)
The world's largest fund, the PIMCO Total Return Fund, contains a quarter-trillion dollars' worth of low-risk bonds. It gained a solid, if unspectacular, 6.22% over the past year, and an annualized 6.90% over the past decade. The expense ratio is on the low side at .46%. The fund's manager, Bill Gross, is the very antipode of a brash Wall Street whippersnapper: he's been managing the fund for 41 years, and he even lives on the opposite coast from New York. Though, that's just one example.
The Bottom Line
Experience counts in fund management, and not just for the obvious reason. Not only do the incompetent managers not stick around long enough to become veterans, but the veterans have enough assets on hand that they can afford to charge low expense ratios. Self-fulfilling? Perhaps, but not at all irrelevant. Even though we're already three months in, no one can say with certainty who 2012's top-performing fund managers will be. Yet, we can say that the ones who make it the easiest for us to buy their offerings (and their expertise) have an inherent advantage.