Most investors are familiar with mutual fund basics and understand how to invest in these assets. They offer the great advantage of spreading risk out among hundreds or even thousands of varied holdings. In fact, the diversification can extend not only to different stocks, but different categories and even asset classes, depending upon the specific fund. However, choosing the top rated mutual funds (or even solid funds) can be a bit tricky.
The sad fact of the matter is that many investors simply pick a fund for emotional reasons. Their philosophy is essentially hope and pray, without much research. Another sad fact about mutual funds is that there are thousands to choose from and as many as 80% fail to beat the market, when compared to the performance of the S&P 500.
While fund managers are all professionals, it is certainly possible that some just make bad stock (and asset) selections. Others make decent selections, but are just not able to overcome their high fee structure (since this, in effect, reduces the rate of return of a fund).
Finding top rated mutual funds
There are a number of tools and methods which can be used to find good mutual funds. Most useful are those websites which provide lists and ratings of funds. The better ones will have these organized by categories, so that investors are able to easily focus only on those which they are interested in.
Here is a great list on Yahoo business: http://finance.yahoo.com/funds/
And this one on MSN money has some excellent pre defined searches: http://money.msn.com/investing/mutual-funds-search.aspx
Of it is possible for investors to do their own research. It seems as if almost every financial newspaper, magazine or website is constantly running a list of the best funds or which mutual funds are worthy of purchase today. Of course, these selections are just as likely to change tomorrow.
One of the best pieces of advice an investor can learn about mutual funds is to focus on the manager. People often think that a professional fund manager should be able to beat the S&P and easily be above average in their particular category. However, one should not forget that they are competing against hundreds of other professional managers. They are ‘paid to play’ as well. Investors would also do well to remember that a fund which has holdings similar to other funds will most likely achieve similar results. Conventional thinking will usually produce conventional results. Find a manager who is a bit different from the rest of the crowd.
Narrowing the field
The first thing investors should do when actively searching for top rated mutual funds is to find those with the top past performances. It is helpful to use the Morningstar ratings for this. Look within specific categories using the fund selector. Next, take a look at the fees and subtract these out to determine the actual returns to an investor. There is a separate fees and expenses section within Morningstar to make these easy to find.
Another option is to focus on index funds or ETFs. There are both pros and cons with these funds. The whole idea is that these funds will essentially track the market or index. They need only minimal management and also should charge lower fees and expenses, since holdings turn over far less frequently. On the other hand, those investing in these funds will never significantly beat the market, but they should not do much worse either. ETFs vs. mutual funds looks at this choice in more detail.
Importance of fees and expenses
In a Morningstar study, funds were placed into five different categories, based solely on the amount of fees charged. Those funds which charged the least (in the bottom category) were more than twice as likely to beat the average fund in their category than those in the most expensive category.
According to the above study, it seems that the fees charged by a fund are the most critical factor to its performance. Many of the top rated mutual funds do charge very low fees. This is encouraging. However, it is not the end of the story. In fact, almost half of those funds in the lowest fee category still failed to beat the average performance of their category. This study was conducted over a ten-year period.
Other important criteria
To summarize, finding top rated mutual funds begins with searching for high performance. Then, an investor needs to look at the fees and expenses involved. Most studies seem to indicate that the cut-off point for expenses is 1.75%. Therefore, the best advice is to only select high performing funds with fees and expenses under 1.75%. Additionally, look for funds with turnovers no more than 50% (of their yearly holdings). Furthermore, avoid funds which have loads. No load funds will generally have lower fees overall.
In addition, find out as much information about the fund manager as is possible. With the internet, doing such research is relatively easy. Look for only those with a proven track record of beating the S&P, a long tenure and a sound investment philosophy. Finally, one should remember the statement that conventional thinking (and investing) leads to conventional results.
The best funds are managed by those who like going against the grain. They do not necessarily need to be big risk takers, but nor should their portfolios or holdings look eerily similar to an index or that of the next fund in their category.