Before you invest in a mutual fund, you need to know more about it than simply whether it appeared on a best mutual funds list. Although some of the funds that make these lists are undoubtedly good, using them as the sole basis to pick the mutual funds that you will invest in is a mistake. Many best-of lists feature the top-performing funds over a short or specified period of time. To find mutual funds that have a chance to be top performers over the long run, you need to dig a bit deeper.
In recent years, index mutual funds that passively mimic the performance of market benchmarks like the Standard & Poor's 500 index have gained in popularity because of their low costs, their investing style and, in many cases, the fact that they outperform many actively managed funds in the same fund category. To choose a mutual fund that is not just popular but also has a better chance of producing long-term results for your portfolio, assess it in terms of the following four characteristics that the best-performing mutual funds have in common.
For any investment vehicle, there are some factors within your control and some that are not. An example of a factor that you cannot control is the direction of the stock market. A key factor that you can control is knowing the expense ratio of the mutual funds that you choose to invest in.
A 2010 study by independent investment research firm Morningstar showed the impact of low expenses in fund performance to be quite significant. In every mutual fund investment category studied, the lowest-cost quintile of funds outperformed the highest-cost quintile by a decent margin.
Similarly, a Vanguard study showed the impact of differing levels of annual fees on a hypothetical $100,000 initial account balance over 30 years with a yearly return of 6 percent. After 30 years, the balance in the account would be:
• $574,349 with no mutual fund expenses
• $532,899 with mutual fund expenses of 0.25 percent
• $438,976 with mutual fund expenses of 0.90 percent
When assessing mutual funds, consider prioritizing funds with low or no expenses because they can potentially perform better for you in the long run.
Strong fund management
One of Morningstar's key tenets in ranking of mutual funds is a strong manager or management team. Beyond just the fund manager, top mutual funds also have a solid group of analysts who research the stocks or other investments bought and sold by the fund managers. Additionally, traders help make sure that the fund trades are properly executed. Even for index funds, the underlying manager can have an impact.
A manager change in a mutual fund that you hold should be viewed as a huge red flag, and you should watch the fund closely. Learn as much as you can about the new manager and find out if he or she will be changing the investment process or other factors that have made the fund a success in the past.
You need to fully understand the costs and the investment strategy of any mutual fund before you invest in it. For actively managed funds, look at the fund's investment process. Consider the following questions:
• Is the fund consistent?
• Does it differentiate the fund from its benchmark index?
• What makes it different from other funds (in a positive fashion)?
• Is this process sustainable year in and year out?
It is important that you are able to understand the fund's investment process and why this process is presumably better than other investment options available to you. If you can't answer the question "Why should I invest my money here?" then the answer is that you probably shouldn't.
Strong parent company
Running a mutual fund is a complex proposition that requires more than just a skilled manager to be successful. Having a strong parent company can help with the recruitment of talented support staff. A strong, ethical parent company can set the tone for all of its funds in terms of stewardship.
A 2014 report by Morningstar named four fund families as the recipients of its top stewardship grades — Vanguard, T. Rowe Price, Dodge & Cox, and American Funds — noting that they also had been successful in terms of Morningstar's success and risk-adjusted success ratios.