3 Ways to Pick the Best Performing Mutual Funds

Investing in mutual funds is an easy way to diversify your portfolio and tap into the stock market with little effort.

Some of the main advantages mutual funds offer are professional management, diversification and a low barrier to entry. However, with the wide variety of mutual funds currently available, finding the best performing mutual funds can be a major challenge.

Moreover, today’s winners can quickly find themselves on the bottom of the pile tomorrow. According to recent figures from S&P Dow Jones Indices, of the 703 stock mutual funds in the top quartile of all mutual funds in March 2011, only 4.69% of remained there by March 2013.

Here are three tips that will help improve your odds of picking the best performing mutual funds for the long haul:

  • Fees and performance are related: According to a 2010 study from Morningstar, fees are a good indicator of the best performing mutual funds—but not in the way you might expect.

    According to Morningstar research quoted by ThinkAdvisor.com, lower-expense funds consistently outperformed higher-expense funds—and fees turned out to be a better barometer of future returns than Morningstar’s own star rating.

    “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds,” wrote Russel Kinnel, the study’s author.
  • The best performing mutual funds stick to their mandate: You’ll want to look at the fund’s history to ensure that its investments match up well with its objectives. Funds that wander off the mark are more risky and can skew your portfolio diversification.

    “For example, if you are investing in a health care mutual fund and see that they have held large positions in Facebook (NasdaqGS: FB) and Apple (NasdaqGS: AAPL), you should probably stay away because you have no idea what they’ll invest in going forward,” wrote InvestorPlace contributor Joanna Pratt in a July 2013 article.
  • Consider exchange traded funds: Unlike traditional mutual funds, exchange traded funds (ETFs) are not actively managed. Instead, they track indexes, commodities or other investments. They trade on stock exchanges, just like stocks, so you can buy and sell them, as well as sell them short, through your broker. That’s different from units of a mutual fund, which are priced at the end of each trading day.

    For example, a popular ETF in the U.S. is the SPDR S&P 500 ETF (AMEX: SPY). The fund aims to duplicate the performance and yield of the S&P 500 index, which consists of the 500 largest companies in the U.S. by market cap, minus fees and expenses. Its expense ratio is just 0.09%.

    A major advantage that ETFs hold over mutual funds is significantly lower fees, because you aren’t paying for professional management to guide the fund.

    This adds up to a substantial savings: according to Morningstar figures published by the Financial Industry Regulatory Authority (FINRA), the average total operating expenses of U.S. large-cap stock mutual funds came in at 1.31% of assets, while comparable ETFs averaged just 0.47%.