The Mutual Fund Traits That Matter

The great thing about our annual mutual fund guide is the large number of funds it covers and the significant amount of information it provides about each fund. As useful as this data is, it can admittedly be overwhelming to a person without a plan for identifying a new fund (or funds) to invest in. Fortunately, this does not have to be the case. I’m going to walk you through the basic steps you need to follow when selecting a new mutual fund. This advice is, in large part, also applicable to exchange-traded funds (ETFs) and closed-end funds (CEFs).

I realize the first thing many of you want to me to discuss is performance, but I would encourage you to take a step back momentarily and consider a more important trait: a fund’s category. Your very first question when selecting a fund should always be “what type of fund am I looking for?” Are you in need of a bond fund? Do you want a fund manager to handle asset allocation decisions for you? (A target-date or balanced fund works well for this.) Are you seeking exposure to international markets? Answer this question first and you will save yourself considerable time. You will also make a better decision about which fund to buy.

Since performance is on most of your minds, let’s talk about it. Recent performance (e.g., one-year) attracts headlines, but five- and 10-year performance figures give much better insight into how a fund has truly performed. Having written about many funds, I can tell you that there is no substitute for looking at the year-by-year return data as well as how the fund performed during the last bull and bear markets (if the fund is old enough to have calculated returns for both). These numbers reveal how volatile a fund has been and can suggest the types of markets the fund fares well or poorly in.

I’ll give you an example. Matthew 25 (MXXVX) has the best five-year annualized performance among non-leveraged large-cap funds. If you were to solely select a fund based on its five-year annualized return of 22.9%, you would think that Matthew 25 is a long-term winner. A look at the year-by-year returns might change your opinion, however. The fund has underperformed the large-cap category average during five out of the last 10 years, including last year.

This brings up another big point: Compare a fund against its peers. Fund managers are beholden to their objectives. If a fund’s category has a lackluster year, as emerging market stocks did in 2014, there isn’t a much a manager can do. While you could focus your efforts on the categories with the best recent returns, by doing so you will always be chasing short-term performance.

You should also look at how long a fund’s manager has been at the helm. Whenever a fund manager leaves, particularly one who follows a hands-on active approach, the fund’s performance walks out the door with him or her. (Bill Gross’ departure from PIMCO is a good example.) The departure of a manager is far less of a problem for funds following a quantitative approach and it shouldn’t be an issue for index funds.

These steps alone should narrow the down the number of candidates to a workable list. From here, you can get into details such as the fund’s expense ratio, its strategy and account minimums. Lower costs are always preferable. Looking at the fund’s prospectus, reading the manager’s commentary (if it is provided) and looking at the top holdings will provide insight into how a fund is run. For example, Wasatch-Hoisington US Treasury (WHOSX) has realized its good five-year performance by making large bets that interest rates will stay low. Account minimums and any minimum requirements on subsequent investments will indicate the smallest amount you can invest in a fund.

Finally, once you buy a fund, take a long-term view. Constantly buying and selling based on short-term performance often leads to worse returns. While you shouldn’t hold onto a long-term laggard, you also shouldn’t be quick to sell just because of one bad year, especially if the fund’s category peers also struggled.