A diversified portfolio of high-performing mutual funds can provide an investor with an excellent vehicle for accumulating wealth. However, with thousands of possibilities to choose from, selecting the proper funds to invest in can be an overwhelming task. Fortunately, there are certain characteristics that the best-performing funds seem to share.
Using a list of basic characteristics as a way of filtering, or paring down, the massive list of all possible funds available for consideration can greatly simplify the task of fund selection, as well as increase the probability that an investor's choices become profitable.
1. Low Fees or Expenses
Mutual funds with relatively low expense ratios are generally always desirable, and low expenses do not mean low performance. In fact, it is very often the case that the best-performing funds in a given category are among those that offer expense ratios below the category average.
There are some funds that charge substantially higher-than-average fees and justify the higher fees by pointing to the fund's performance. But the truth is there is very little genuine justification for any mutual fund having an expense ratio much over 1%.
Mutual fund investors sometimes fail to understand how big a difference even a relatively small percentage increase in fund expenses can make in the investor's bottom-line profitability. A fund with a 1% expense ratio charges an investor with $10,000 invested in the fund $100 annually. If the fund generates a 4% profit for the year, then that $100 charge takes away a full 25% of the investor's profits. If the expense ratio is 2%, it takes half of the profits. But an expense ratio of 0.25% only takes 6% of the investor's total profit. In short, expenses are of critical importance for mutual fund investors, who should be diligent in seeking out funds with low expense ratios.
In addition to the basic operating expenses charged by all funds, some funds charge a "load," or a sales fee that can run as high as 6% to 8%, and some charge 12b-1 fees used to cover advertising and promotional expenses for the fund. There is no need for mutual fund investors to ever have to pay these additional fees, since there are plenty of perfectly good funds to choose from that are "no-load" funds and do not charge any 12b-1 fees.
2. Consistently Good Performance
Most investors utilize investing in mutual funds as part of their retirement planning. Therefore, investors should select a fund based on its long-term performance, not on the fact that it had one really great year. Consistent performance by the fund's manager, or managers, over a long period of time indicates the fund will likely pay off well for an investor in the long-run.
A fund's average return on investment (ROI) over a period of 20 years is more important than its one-year or three-year performance. The best funds may not produce the highest returns in any one year but consistently produce good, solid returns over time. It helps if a fund has been around long enough for investors to see how well it manages during bear market cycles. The best funds are able to minimize losses during difficult economic periods or cyclical industry downturns.
A large part of consistently good performance is having a good fund manager. Investors should review a fund manager's background, previous experience, and performance as part of their overall evaluation of the fund. Good investment managers do not usually suddenly go bad, nor do poor investment managers tend to suddenly become overachievers.
3. Sticking to a Solid Strategy
The best-performing funds perform well because they are directed by a good investment strategy. Investors should be clearly aware of the fund's investment objective and the strategy the fund manager uses to achieve that objective.
Be wary of what is commonly called "portfolio drift." This occurs when the fund manager drifts off course from the fund's stated investment goals and strategy in such a way that the composition of the fund's portfolio changes significantly from its original goals. For example, it may shift from being a fund that invests in large-cap stocks that pay above-average dividends to being a fund mainly invested in small-cap stocks that offer little or no dividends at all. If a fund's investing strategy changes, the change and the reason for it should be clearly explained to fund shareholders by the fund manager.
4. Trustworthy, With Solid Reputations
The best funds are perennially developed by well-established, trustworthy names in the mutual fund business, such as Fidelity, T. Rowe Price, and the Vanguard Group. With all the unfortunate investing scandals over the past 20 years, investors are well-advised to do business only with firms in which they have the utmost confidence in, in regard to honesty and fiscal responsibility. The best mutual funds are invariably offered by companies that are transparent and upfront about their fees and operations, and they do not try to hide information from potential investors or in any way mislead them.
5. Plenty of Assets, but Not Too Much Money
The best-performing funds tend to be those that are widely invested in but fall short of being the funds with the very highest amount of total assets. When funds perform well, they attract additional investors and are able to expand their investment asset base. However, there comes a point at which a fund's total assets under management (AUM) become so large as to be unwieldy and cumbersome to manage.
When investing billions, it becomes increasingly difficult for a fund manager to buy and sell stocks without the size of their transaction shifting the market price, so it costs more than they would ideally wish to pay to acquire a large amount of a specific stock. This can be particularly true for funds that seek undervalued, less-popular stocks. If a fund suddenly looks to buy $50 million worth of a stock that is ordinarily not very heavily traded, then the demand pressure injected into the market by the fund's buying could drive the stock's price substantially higher. This would make the stock less of a bargain than it appeared when the fund manager evaluated it prior to deciding to add it to the portfolio.
The same problem can occur when the fund seeks to liquidate a position in a stock. The fund may hold so many shares of the stock that when it attempts to sell them, the oversupply may put substantial downward pressure on the stock price so that, although the fund manager intended to sell the shares at $50 a share, by the time he is able to fully liquidate the fund's holdings of the stock, the average realized sale price is only $47 a share.
Investors may wish to look for mutual funds that are well-capitalized, indicating the fund has successfully drawn the attention of other individual investors and institutions but has not grown to the point where the size of the fund's total assets makes it difficult for the fund to be managed adroitly and efficiently. Problems in managing the fund's assets may arise as the fund's total assets grow beyond the $1 billion level.
The Bottom Line
Selecting mutual funds is always a personal endeavor that should ultimately be guided by the individual's investment goals and plans, their risk tolerance level, and their overall financial situation. However, there are some basic guidelines investors can follow to streamline and simplify the fund selection process, and hopefully result in the investor acquiring a profitable portfolio of funds.