How to Pick Active Mutual Funds (If You Have to)

“Investors should remember that excitement and expenses are their enemies.” – Warren Buffett

Index funds and ETFs make the most sense as an investment vehicle for investors for a number of reasons. They have lower expense ratios than active mutual funds. They are more tax efficient. They trade less so they have lower transaction costs.

And the most important feature of the index fund is the fact that they tend to outperform the majority of active mutual funds over numerous investment periods, but especially over the long-term.

Unfortunately, for those investors that have the bulk of their retirement funds in their 401(k), the index fund options may be limited or non-existent. Most of the fund companies make much more money from the fees on their active mutual funds, so those are the ones that a lot of us find for our retirement fund options.

You don’t want to miss out on the tax benefits, potential company match and automation that the 401(k) or similar plans can offer. Therefore if you don’t have index fund offerings in some of the asset classes you would like to invest in you will have to have a system for choosing an active manager.

MUTUAL FUND SELECTION CRITERIA
Here is a list of some quantitative and qualitative factors that you can use to select active mutual funds:

Portfolio Manager Tenure
The longer the portfolio manager or team have been together the better. That way you know that the investment approach was developed and past performance achieved with the current manager or team in place.  If a portfolio manager has only been around for a year or two it will be difficult to determine if the track record and investment style will be consistent with the history of the fund.

Shareholder Letters
Read quarterly or annual shareholder letters to get a better idea of the manager’s style, investment outlook and general approach to portfolio management. They should be able to tell what they got right, what they got wrong and plans for dealing with the future investment environment. Reading these letters lets you know how well they can articulate their investment process.

Low Portfolio Turnover
You should want to partner with long-term investors so try to shoot for a turnover ratio of between 30% and 50%. That would mean that the average holding period for their stocks is 2-3 years. Mutual funds with 100% turnover are basically changing the entire portfolio once a year. The more turnover in the fund, the more they are trading.

Just like you pay to make stock trades in a brokerage account, mutual funds incur transaction costs when they trade. The more they trade, the higher the costs and the higher the costs, the lower your returns.

Historical Performance
Past performance is no predictor of future results (they make sure to tell you this in writing). This is true but you can still view a fund’s return numbers to see how they have fared in comparison to their benchmark and against different market cycles. Take a look at how they have performed when stocks and bonds are rising or falling to see how they handled those environments.

If they have been around long enough you can check how they handled the bear market from 2000 to 2002, the subsequent recovery through 2007, the route in 2008 and the recovery since 2009. We’ve had two pretty full market cycles in the past decade and a half so you should be able to get a really good idea of how they have performed through the manias and panics.

Don’t focus so much on short-term performance. Long-term performance is much more important to gauge the manager’s investment track record.  Look at the 5, 7 and 10 year returns.

Costs
If you judge an active fund by one measure, this should be it. Check what their expense ratio is. Less than 1% is ideal. Make sure there are no sales charges (sometimes called front end loads) or 12b-1 expenses. These are simply fees that fund companies use to suck you dry and eat away your returns through excessive fees. They serve no purpose for your investments.

Morningstar came out with a research report a couple of years ago that found that expense ratios were a better predictor of future performance than the five star rating system they developed for mutual funds. Here is what Morningstar’s director of research had to say at the time:

“Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you’ll be on the path to success.”

The higher the expense ratio charged by a mutual fund the higher the hurdle rate that they have to jump over to make up for with their investment performance. Index funds charge somewhere in the 0.10% to 0.20% range while active funds average around 1.40%. Making up over 1% a year through security selection can be difficult for even the best portfolio managers.

A recent study showed that these fees can be substantial. Over a lifetime, fees can cost a median-income double income family nearly $155,000.

Also, a recent AARP study reported that 70% of investors in mutual funds were not even aware that they were paying any fees at all (because the performance fees are taken right out of the fund and not necessarily billed to each investor).  Pay attention to fees.

WHERE TO FIND THIS INFORMATION
You should be able to get all of this information easily from your retirement plan provider. They should offer a one or two page fact sheet for each fund.

You may have to do some research on your own if they don’t include everything you need. Simply enter the fund’s ticker on Morningstar’s website (or almost any financial website) and you should be able to get all of this information in one place. Plus there will be much more such as the fund’s style, asset allocation, top holdings, sectors and much more.

Also, make sure you are reviewing this information on at least an annual basis to make sure there haven’t been any major changes to the fund’s structure.  But do not try to trade in and out of funds on a regular basis.

Even the best long-term investors suffer periods of underperformance once and a while.  You should make sure that they are keeping fees low and sticking to their knitting with a stable investment process.

It would be nice if every investor was offered simple, low-cost index funds to invest in. There are good active mutual funds out there, you just have to know what to look for.  Start by looking for funds with low expense ratios and go from there.

Sources:
Fund Expenses More Important than 5-Star Status
“The Retirement Gamble” Facing Us All
The Retirement Savings Drain

How do you select your mutual funds?  Any other criteria that I failed to mention?

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