When choosing mutual funds, few aspects are within investors' control. Future performance isn't one of them. But expenses, risk, manager tenure and tax-efficiency are qualities that can be judged before you buy.
Experts say you need to look beyond just performance. You need to understand what will make a fund do well in the future and why it belongs in your portfolio.
What to watch for
Index funds, which track a basket of stocks, are generally low-cost options intended to provide market-like returns. Active management, in contrast, relies on a professional's stock-picking in an effort to beat a market benchmark.
Yet an actively run stock fund is much more than an expert's collection of chosen stocks. You're putting money behind a manager, a fund company and a philosophy about investing, trading, taxes and risk. But what makes a fund manager think they can outperform?
Answers to these questions and others can be found, easily enough, on fund-company Web sites, where it's typical to find quarterly manager commentaries. Some managers are quite forthcoming about the reasons for their investment decisions and what they've learned from any mistakes.
All things being equal, such open-minded fund managers are keepers for your short list. Honest and timely messages from managers show respect for shareholders that likely extends to other important, investor-friendly attributes: low expenses, investment consistency, strong research analysis, sound corporate governance and managers' own money on the line.
A basic and very simple strategy that works well for many investors is a simple, well-diversified portfolio ranging from just three to 11 low-cost, no-load index funds that will create a long-term winner through bull and bear markets. And you do it with no market timing, no active trading and no commissions.
What to watch out for
Paying too much: You have to care about expenses. They are the most predictable characteristic of explaining future returns of funds, experts say. And expenses are a more reliable signal than past performance.
It can't be said enough: with funds, costs matter. Annual expenses eat into total return, year after year. With high-cost funds, you pay more and pocket less. Moreover, studies show that low-expense funds are more likely to outperform their costlier counterparts over time.
Taking excessive risk: No risk, no reward, as the old saying goes. Maybe you've found an attractive fund with a great multiyear track record. But just how attractive the fund is will be determined by how the manager generated that return.
Better to invest with a manager who delivered superior gains with minimal risk.
In looking for how returns were achieved, check the fund's annualized results for unusual highs and lows. Then compare those figures with its category peers.
Morningstar's site, is a good source for in-depth research and screening tools to find solid performers. Mutual Fund Observer is another good resource.
Portfolio overlap: If one fund is good, then two or even three similar funds must be better, right? Not so. Maybe you can't be too rich or too thin, but you can be too diversified. Funds of the same stripes will likely hold many duplicate stocks.
This is especially true of large-capitalization funds, where companies with the biggest market values tend to command a meaningful chunk of the portfolio's assets. You may think you have different and diversified investments. But instead, you really just have one big investment of the same kind.
More on Mutual Funds and ETFs
Don't be a fund collector. Copycat funds bloat your investment portfolio and drag down performance. At some point, the blend will produce bland, index-like results at a high cost. Plus, heavier concentration in a few stocks adds risk.
So how many funds do you need?
Experts generally say you need no more than three fund in any asset class, and how many you have in total depends on your asset allocation. That generally would be around a dozen or so.
Recent manager changes: A fund's performance doesn't always speak for itself. Funds are ranked, rated and rewarded on the strength of returns over several years. But if a manager is new, those results are no longer a litmus test.
Check Morningstar's website or the fund's prospectus to find out how long managers have been on the job and their employment history. Manager tenure isn't as crucial when a fund is team-managed, has a deep bench of stock analysts or when a successor brings a solid showing from another fund.
Investment strategy 'drift': A burst of trading activity, venturing into new market sectors, adding larger-cap stocks, taking an aggressive stance in a volatile market — these are all telltale signs that a fund has changed its investment strategy, and not always for the better. When a manager alters their strategy, you need to know if that new portfolio is a good fit for you or if it's a sign the manager is failing.
Informed investors pick funds for their diversification capabilities. Like a baseball team, funds exhibit skills that are sharpest when each plays its position well. A portfolio will have a large-cap fund that follows a value investment discipline, and one with a bias toward growth stocks. There are mid-cap and small-cap funds covering similar growth and value styles. If these aren't working together, the strength and quality of your portfolio is weakened.