5 Secrets of Picking a Good Mutual Fund

Analyzing past performance and rankings may not get you the best possible return on your money.

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Mutual funds are big business. In excess of $12 trillion is invested in approximately 11,000 mutual funds in the U.S. Most them are actively managed funds, where the fund manager attempts to beat a designated benchmark, like the S&P 500 index.

The fees charged by these funds are huge, but they are not clearly disclosed and are the subject of intense debate. The actual cost of owning them can range from an average of 1.17 percent to 3.37 percent of fund assets, depending on whether you include taxes, trading commissions, and other hidden costs as part of the fees you pay. Here are five secrets that will help you find the best fund for your money:

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1. Most actively managed mutual funds don’t provide higher returns. As a group, actively managed funds have a dismal record in equaling–much less beating–their designated benchmark. Approximately two-thirds of actively managed mutual funds underperform their benchmark each year. This is true for domestic and international stock funds and for fixed income funds.

2. Past performance isn’t an indicator of future performance. A big part of the mutual fund sales process involves touting past performance numbers of carefully selected funds. The message being conveyed is that a fund that has done well in the past is likely to outperform in the future. The data indicates this is not true. In one study of 1,085 domestic stock funds that landed in the top half in the first year of a five year period, only 45 maintained that standing in all the remaining years. By random chance alone, there should have been 68 repeats.

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3. Many mutual funds disappear and aren’t included in reporting. Mutual fund families are only required to report the returns of funds in existence. Many funds that underperform are merged into better performing funds or are liquidated. Over an extended period of time, up to one-third of actively managed mutual funds disappear. Mutual fund families hype the returns of their existing funds by ignoring the dismal returns of the funds that were phased out.

4. Don’t get Morningstar’s stars in your eyes. Brokers and fund families love to tout their five-star Morningstar ranking. However, the star rating of a fund is not predictive of future performance. Don’t believe me? Here’s a quote from Don Phillips, president of fund research at Morningstar: “The Morningstar Rating for funds is a grade on past performance. Period. No one at Morningstar ever claimed that the stars have predictive power or ever ran an ad telling investors to follow the stars to riches.” It’s simply misleading for the star rating of actively managed mutual funds to be used to persuade investors the future performance of the fund is likely to mimic its past performance.

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5. Taxes matter. Actively managed funds have far greater turnover in their portfolios than index funds. This makes sense because the active fund manager is buying and selling in an often futile effort to beat the markets. Vanguard founder John Bogle studied after-tax returns of active funds and index funds over a 16-year period. He found that investors in actively managed mutual funds kept only 47 percent of the cumulative return of the average actively managed mutual fund. How did index fund investors do? They kept 87 percent of those returns. It’s not what you make, it’s what you keep that counts.

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.