5 Ways to Find the Best Mutual Funds

History, ownership, size, and fees all make a difference.

By SHARE

An adviser or pundit on television or in the press recommends a mutual fund. Do you rush out and buy it? No way! Before you buy, analyze that fund as you would any other large, important purchase—such as a new car. Along with the sticker price, you'll want to know if that shiny new car has above-average gas mileage, a powerful engine, and strong control in nasty weather. You also want to check the car's interior. Does it have plush automatic leather seats and a good sound system? Likewise, when you're considering buying a mutual fund, you have to look under the hood to examine the type of holdings that are powering it, how much it costs, who's at the steering wheel, and that person's past performance. Here are five things to look for in a mutual fund before you buy:

1. The fund manager's tenure and record. The key to a fund's success is the fund manager. Don't buy into a fund because of brand name alone. The fund manager is like the quarterback of the football team. He knows when to buy stocks, throw them away, or just hold on and let them run. Some quarterbacks are better than others; Peyton Manning is going to have a much greater chance at winning for the Indianapolis Colts than just about any other quarterback in the league. There is no guarantee that he will win every week, but the Colts have the best chance at winning with Peyton behind center. A good example of a winning fund manager is Peter Lynch, who ran the Fidelity Magellan fund in the 1980s. Lynch got a lot of attention for his stock picking prowess and stellar returns. But ever since he left Magellan in 1990, the fund has struggled to achieve its former glory. So before you invest your money in a fund, invest a little time first. Check the manager's tenure and performance.

[See Is a Retirement Income Fund Right for You?]

2. Size matters. Funds must follow a rule, which the Securities and Exchange Commission (SEC) monitors, limiting how much of each stock the fund can hold. When a fund's assets rise, the manager has more money which can be spread around to different stocks. This means the manager might have to buy stocks that he's not as thrilled about, and if those stocks don't perform as well as his favorite picks, the fund's performance might suffer. Does the manager like stocks 1-50 as much as he or she likes stocks 51–100? We recommend that investors stay under $1 billion in assets for small-cap funds, and below $5 billion in assets for large-cap funds.

3. Fund manager ownership. Under another rule monitored by the SEC, which went into effect in February 2005, fund managers are required to disclose how much they own of their fund (the ownership amounts are not exact—the ownership stakes disclosed are in seven dollar ranges varying from none to $1 million and are as of the most recent fiscal year end). We like when the fund manager is eating his own cooking. Studies have shown that managers with ownership stakes in their fund tend to have better performance.

4. Stick with no-load funds. Fund companies offer different share classes of each fund that carry various sales charges (also called loads) and fees. There's no reason to pay more in fees when you don't have to. Over time, fees and charges lower the return you'll get from the fund. When you find a fund you want to buy, make sure it's a no-load fund. For example, Selected American Shares (SLASX), managed by Chris Davis, is a no-load fund. A similar fund that Davis runs, Davis NY Venture (NYVTX), is sold through advisers and carries a 4.75 percent initial sales charge, so it costs more.

[See 5 Things You Don't Know About 529 Plans]

5. Consistent returns during different calendar-year periods. The financial crisis caused stocks to collapse in 2008. After stocks hit lows in March 2009, prices rebounded strongly, making 2009 a fantastic year for stock returns. We believe this period is a once-in-a-lifetime anomaly, so investors should disregard 2008 and 2009 when judging a fund's historical performance. Instead, look at a fund's returns in 2000, 2001, and 2002 to anticipate how it might perform in a bad market. Then examine a fund's returns in 2003 through 2007 to see how it tends to perform in a good or normal market. You want to own a consistent fund—one that performs well in a good market and doesn't lose as much as a market in tough years.

Of course, I would be remiss if I didn't add that familiar disclosure: Past performance does not guarantee future results.

Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April, 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC registered investment adviser which provides mutual fund and asset allocation recommendations and research to stores in The Mutual Fund Store system.