The Secret to Better Mutual Fund Returns

When you're looking for a new mutual fund, naturally the funds that have done the best lately will attract you. But while the list of top performers will look different from year to year, the funds with the best returns over the long haul share one trait: They keep their costs down.

This month's issue of the Fool's Champion Funds newsletter, which is available today at 4 p.m. ET, takes a close look at putting together a successful investing strategy. Of all the factors you should consider when choosing a fund, low fees is the most basic, but most often overlooked, rule that improves results.

It makes a difference
You might think the idea of choosing lower-cost funds would be obvious. Common sense tells you every dollar your fund managers take for themselves is one less you have to invest.

A study by three Ivy League professors sought to prove that idea. Their subjects, undergraduate and M.B.A. students at Harvard and Penn, were told to choose one of four index funds that were identical except for their varied fees. The majority failed to pick the least expensive option.

That's perhaps easier to understand when you change your perspective. Over short periods of time, it's easy to ignore fees. Especially over the past several years, when many funds have performed well, you're less likely to notice paying 2% or more in expenses if your fund is up 30% or more in a given year.

Eventually, though, those expenses catch up to you. Consider, for instance, the top-performing large blend stock mutual funds over the past 10 years:

Fund	10-Year Annual Return	Expense Ratio	Top Holding
CGM Focus (CGMFX)	24.81%	1.02%	Companhia  Vale Do Rio Doce (NYSE: RIO)
Quaker Strategic Growth (QUAGX)	18.10%	1.90%	Freeport-McMoRan (NYSE: FCX)
Hartford Capital Appreciation (HIACX)	13.74%	0.66%	Google (Nasdaq: GOOG)
Principal Investors West Coast (CMNWX)	12.23%	0.85%	Wells Fargo (NYSE: WFC)
Fidelity Advisor Industrials (FCLIX)	11.66%	0.91%	General Electric (NYSE: GE)
Oakmark Select (OAKLX)	11.64%	0.99%	Washington Mutual (NYSE: WM)
MainStay MAP I (MUBFX)	11.54%	1.03%	Morgan Stanley (NYSE: MS)

You'll notice that just one of the funds has an expense ratio above the average of 1.07% for stock mutual funds. A similar look at the funds at the bottom of the barrel showed nine out of 10 funds with above-average expenses, including five over 2%.

You can't afford it
Unless you have more money than you know what to do with, paying 2% or more in fees is a drag on your portfolio that you just won't be able to overcome. If you invest $1,000 today in a typical stock fund that earns 10% before accounting for expenses, the difference between paying 1% or 2% is huge -- and just gets larger over time.

Years Invested	Paying 1% Expenses	Paying 2% Expenses
5	$1,539	$1,469
10	$2,367	$2,159
20	$5,604	$4,661
30	$13,268	$10,063

Can you afford to give up that much return? With rising retirement costs, college tuition inflation, and even basic living expenses going up, every penny you can keep will help.

To get better returns by reducing your fund costs, you have two choices. Low-cost index funds give you cheap exposure to the market, with expense ratios as low as 0.1%. But if you agree with Champion Funds expert Amanda Kish that the best fund managers can consistently beat the market, paying a little more for a manager isn't necessarily bad. Just keep an eye on your fund's performance, and make sure your managers are earning the money you're paying them.

Check out these articles to learn more about ...

• How to pick winning funds
• Why mutual funds are the best investments ever
• How to find all the funds you want in one place.

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