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Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications and FICS-created content. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.

5 tips to pick a winning fund

Here's how to boost your chances of finding a top fund.

  • By Daren Fonda,
  • Fidelity Interactive Content Services
  • – 05/06/2013
  • Investing in Mutual Funds
  • Mutual Funds
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Go shopping for a mutual fund and it's easy to feel overwhelmed these days: There are more than 8,600 funds on the market and many look compelling, at least on the surface.

Yet picking healthy choices for your portfolio can be tricky, even if you read the labels closely. Many studies have found that the average actively managed fund trails its benchmark over long periods. Over the last three years, managers across all domestic stock categories trailed their index, according to S&P Dow Jones Indices.

Still, there are talented managers who buck the odds. Even if a fund falls short for a year or two, it may wind up outperforming over a full market cycle, including bull and bear markets. And while there's no magic formula for picking a winning fund, there are clues that can boost your chances.

"If you pick the right active fund you really are getting what you pay for," says Justin Rush, a financial adviser with Storey & Associates in Canton, Ohio, who primarily uses active funds for his clients.

The performance puzzle

The first place to start is a fund's track record: Look at how it stacks up against its benchmark index. A fund that beats its benchmark may very well continue to do so, assuming it doesn't change its investment style or managers.

Many advisers recommend looking for funds that have beaten their category averages over at least the past three to five years, which should capture the fund's performance in different markets and economic environments.

Unfortunately, performance data only takes you so far. The evidence is mixed on whether past performance has any predictive value, says Russ Wermers, an associate finance professor at the University of Maryland and co-author of a new textbook on mutual fund evaluation.

Bad funds tend to stay in the bottom ranks, he says, and you should probably avoid them. Conversely, some studies suggest that funds in the top 10% of their category continue to outperform for three to four years. After that, it's anyone's guess how they'll fare.

"You're lucky if you can get three to four years of outperformance," says Wermers. "Longer term, it's almost universally found that there's no persistence in performance."

Behind the numbers

A big difficulty is determining why a fund beat its benchmark. Figuring out whether it was due to the manager's skill, a team effort involving analysts and traders, or just plain luck isn't easy. Indeed, statistical analysis can't distinguish these factors, according to several studies.

Complicating things further is how much risk a manager takes to try to beat his benchmark. Some risk-taking is necessary; otherwise a fund would look identical to its index. But managers may go overboard, investing in highly volatile stocks or riskier bonds in a bid to boost returns. Conversely, they may dial back risk to protect their record, hindering their ability to outperform in the future.

Beyond fund performance, where else can you turn?

One place is fees. A 2010 study by Morningstar found that funds with the lowest annual fees beat the costliest funds in every time period and category. High fees can be a red flag, says Wermers, and can help weed out bad funds. But good managers can be hidden in high-fee categories, he adds, making it important to look at other factors, such as the manager's education, experience and investing strategy.

Here are five more ways to increase your odds of picking a top manager, based on academic studies and research. As always, you should do your own research or consult an adviser before investing.

1. Find smart, experienced managers

Graduating from a top school doesn't guarantee success, but there's some evidence that academic strength is associated with fund performance. A 1999 study found that managers who went to schools with higher average SAT scores had higher returns as fund managers. A 2006 study concluded that the quality of a manager's MBA program was positively related to fund performance.

These studies didn't analyze individual funds, and they don't conclude that all managers from top schools beat the competition. Indeed, manager experience and social connections may offer clues too.

A 2006 study found that more experienced managers of large funds beat less experienced managers by an average of 0.92% a year. Managers who invested in companies in which they had social connections also seemed to fare better with those stocks, according to a 2008 study, possibly because they could better assess the company's management team and prospects.

2. Smaller funds, larger fund companies

Small, nimble funds can have an edge in the marketplace, and many studies suggest that a fund's performance tends to wane as its asset size grows. This can happen for a number of reasons: for example, a star manager retires and gets replaced by someone less talented. Top funds attract lots of money too, and a manager may struggle to find good investment ideas for all the new cash.

While smaller funds may be stronger, though, large fund companies seem to offer some advantages, says Wermers. Big fund companies may benefit from lower fees and trading costs, more resources for research and better technology to execute trades.

These companies may also have more internal competition for top fund manager jobs. And they may be more likely to replace managers who underperform. Indeed, some studies suggest that fund companies with more independent directors perform better, possibly because they're more demanding of fund managers — and less tolerant of laggards.

3. Swim against the tide

Many fund managers describe themselves as "contrarian," buying out-of-favor stocks they think have stronger potential for gains. But does it pay off for investors?

One 2009 study co-authored by Wermers suggests it does, finding that contrarian funds beat "herding" funds by more than 2.6 percentage points a year, on average. Contrarian funds buy and sell stocks moving in the opposite direction of other managers more frequently, according to the study.

One reason the contrarians seem to shine? Many of these funds have lower turnover, leading to lower trading costs. Contrarian managers also seem to focus on companies with stronger finances and more stable profits, generating higher returns, the 2009 paper noted.

Contrarian funds can be risky, of course, and require patience since their picks can take years to bear fruit. Funds with stable risk levels also tend to fare better, according to a 2010 study. You can check a fund's risk measures such as beta and standard deviation at Morningstar.com and Fidelity.com.

4. Go active – really

Many funds invest in a mix of stocks that's similar to their benchmark, aiming to keep their "tracking error" low. But these "index huggers" aren't likely to outperform, offering little reason to pay for active management. Funds that don't mirror their index may be a better bet, according to 2009 study co-authored by Antti Petajisto, a former assistant finance professor at Yale.

According to the study, stronger performers have a high "active share" — the difference between their stock weightings and weightings in their benchmark index. High-active-share funds beat the index huggers by roughly 2.5 percentage points a year, the study found.

Granted, these funds may have fared better because they held more small- and mid-cap stocks, taking more risk along the way. But Wermers says other studies have concluded that more active managers have stronger results, even after adjusting for risk.

While most funds don't report their active share, other measures offer clues about whether a fund is highly active. One is "R-Squared," which looks at how much of a fund's movements can be explained by changes in a benchmark index. A fund with an R-Squared close to 100 closely mirrors its index while an R-Squared below 80 indicates a fund is highly active. You can find a fund's R-Squared on Fidelity.com and other fund research sites.

5. Hire a pro for the tougher jobs

There may be wisdom in crowds, but it's tougher for funds to stand out in a crowded space. Companies whose stocks are widely held and covered by Wall Street tend to reflect all known information, making it less likely their stocks and bonds are mispriced.

Market turmoil or big changes in a sector can create opportunities, though, and active managers have a greater chance of outperforming in areas where information is scarce or costly to obtain, says Wermers.

Some fertile areas to consider? Small-cap stocks, foreign markets and parts of the fixed income market such as mortgage-backed bonds, convertible securities and floating-rate loans are all candidates, he says. These areas tend to be less picked over, enabling savvy managers to swoop in and profit.

Wermers himself uses active managers for about half of his portfolio, and he tends to stick with the funds for long stretches, even if they have a bad year or two.

"You want to spend money on a pro when you don't have the resources and can't do the analysis yourself," he says. Plus you need patience for the investment to pay off.

Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com.

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© 2008-2013 Fidelity Interactive Content Services LLC. All rights reserved.
Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications and FICS-created content. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.
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