The Case for Mutual Funds

As generous as folks have been in response to my Motley Fool Champion Funds service, I can't help suspecting that there are doubters among you yet. And I know what you're thinking: Isn't a mutual funds service inconsistent with what a Motley Fool believes?

Point taken
Seriously, that's a fair question. We've taken some potshots at that "typical" mutual fund for years, but let me answer it loud and clear right now: Champion Funds is 100% consistent with the Fool's message. To the extent that there's a new wrinkle, I'd argue that it's a matter of emphasis. In the past, we've focused on the majority of funds that underperform the market; now we're focused on finding those that don't.

And quite a few funds actually have beaten the S&P 500 over time. Crunching the data from Morningstar, we see that more than 700 domestic-stock funds did so for the 10 years ended with November 2006. Meanwhile, nearly 1,700 funds outperformed for the trailing-five-year period. (Yep, you read that right.) What's more, that list includes funds from all over the style and market-cap spectrums, and that tells me that they're headed by talented stock pickers, not by folks who just happened to find themselves in the right place at the right time.

Fidelity Fifty (FFTYX), for instance, is a fairly aggressive growth fund whose portfolio recently included the likes of Maxim Integrated Products (Nasdaq: MXIM), Electronic Arts (Nasdaq: ERTS), and UnitedHealth (NYSE: UNH). T. Rowe Price Value (TRVLX), meanwhile, sticks to the value side of the aisle, generally investing in companies with lower P/Es, a group that currently includes long-haul overachievers Wal-Mart (NYSE: WMT), General Electric (NYSE: GE), and international energy concern Total SA (NYSE: TOT).

Fund facts
Of course, past performance is only so useful when it comes to gauging a fund's future prospects. Our premise at Champion Funds is that you're more likely to find tomorrow's winners if you bring a comprehensive set of principles to bear on the universe of mutual funds and see which ones pass muster. Performance is one screen I use, but I also focus on fees, volatility, tax efficiency, managerial tenure, and strategy. Fancy-shmancy analytical types might call it a "mosaic" approach. I prefer to say that I ask a consistent set of questions and then use the answers to separate the champs from the duds.

Far beyond the revelation that finding funds that can beat the market is more doable than you might have imagined, the case for mutual funds goes on. For starters, well-chosen funds can provide quick and easy exposure to the market's various sectors and industries, lending your portfolio the kind of diversification that can help insulate you from volatility during turbulent times. No single piece of bad corporate news is likely to sink your fund, as it might an individual stock.

And that's true even if the bad news involves the fund families themselves. Even those who owned funds implicated in the trading-abuse scandals a few years back had little reason to dump their shares the moment the sorry news broke. Because the value of funds is a function of their underlying holdings, those unfortunate shareholders had ample time to weigh the tax implications of selling and determine where they'd park their money next.

Funds also provide easy access to relatively esoteric asset classes. When, for instance, was the last time you bought a convertible or high-yield bond? How 'bout stocks from the emerging markets of Russia, Brazil, or South Korea? Securities such as these can play a role in many an investor's portfolio, and mutual funds make it easy to increase your exposure to them.

Last but not least, there's cost. Unlike with stocks, you don't have to pay a broker a commission each time you buy mutual fund shares. And though that much-maligned "typical" fund sports an expense ratio of around 1.4%, some of my favorite funds cost less than 1% per year.

Choosy investors choose champs
Not for nothing, in other words, are mutual funds the investment vehicle of choice for so many of us. They're convenient, cost-effective, and a lot less risky than individual stocks. And for folks who have things to do other than check their stocks every five minutes, mutual funds provide a peace-of-mind alternative (or supplement). Indeed, for serious long-term investors, I'd argue that mutual funds are just about the perfect investment vehicle.

The point is -- and this is where many passive investors go astray -- what fund you buy matters, and it matters a lot. The essence of Foolishness has always been that investors willing to do their homework can whip up on the Gucci-loafered Wise with one hand tied behind their checkbooks. Picking the right fund is every bit as important as picking the right stock, if not more so.

How so? For one thing, much as we all like to regard ourselves as buy-and-holders, when it comes to individual stocks, too many of us fail that test. With funds, at least, we tend to be better behaved. We tend not only to buy and hold but also to keep investing new money in our funds in good markets and bad.

Good for us -- assuming we've picked right to begin with, of course.

Motley Fool Champion Funds highlights only the best of the best funds -- the relatively few that make it through the obstacle course of Shannon's strict proprietary criteria. You can access every back issue and the complete list of recommended funds for free with a 30-day risk-free trial.

This article was originally published on June 8, 2004. It has been updated.

Fool fund guru and Champion Funds analyst Shannon Zimmerman does not own shares of any security mentioned in this article. UnitedHealth and Wal-Mart are Motley Fool Inside Value picks. UnitedHealth and Electronic Arts are Stock Advisor choices. Total SA is an Income Investor selection. The Motley Fool has a disclosure policy.