Mutual fund ads, which often tout a fund’s past performance, always include this bit of fine print: “Past performance is no guarantee of future returns.” Pay attention to that disclaimer. Not only is past performance no guarantee, it’s not even a very strong indicator of a fund’s future success. A recent study by Standard & Poor’s found that of all funds in the top 25% of their category in one year, fewer than one third made it to the top 25% the next year. Only 5% managed to stay in the winner’s circle three years in a row.
So how do you pick a good fund? Each year, Money magazine puts together a list of 50 recommended funds. Performance is one of the editors’ criteria, but it’s the least important among many. Money also considers:
Low fees: If one fund charges an annual expense ratio of .4% and another charges 1.4%, the cheaper fund has a built-in 1% edge on returns every year. Remember, you can’t count on a fund manager outperforming or even making you money. But you can count on him collecting his expense ratio. For this reason, the Money 50 list is heavy on low-cost index funds.
Experienced management: A fund is nothing but a pool of money. If performance records matter at all, they belong to the manager not the fund. So if a fund switched managers last year, you truly can ignore most of its record.
Strong stewardship: Money looks for funds whose managers consistently put shareholders’ interests ahead of their own. That means having pay incentives aligned to performance, a strong board to represent fund shareholders, and record of avoiding regulatory issues. Morningstar, a fund research group based in Chicago, assigns funds a stewardship grade based on these and other factors. You can look up a fund’s stewardship grade at Morningstar.com.
Make sure you pick a fund with a strategy aligned to your goals. Some stock funds focus on big, stable blue-chip companies with the aim of producing relatively steady returns. Others reach for higher returns—and accept higher risk—by focusing on smaller companies, or on stocks in volatile but fast-growing industries. Most stock investors, however, will do just fine by choosing a low-cost, broadly diversified fund that holds a representative slice of all the stocks on the market.