The Key to Successful Mutual Fund Investing

Successful investing requires a bit of detective work. Before buying any investment, you should do a little digging to find out whether it's right for you. This applies to stocks, bonds, and of course, mutual funds. While you should consider many different factors when searching for funds worth keeping, Morningstar research suggests that one single factor may best predict mutual fund performance.

Key to success
In a study from last year, Morningstar separated funds into five equal groups, ranked by the amounts they charged in fees. According to the firm's research, funds in the cheapest group were more than twice as likely to beat the average fund in their category as those in the most expensive group. Looking at domestic equity funds, nearly half of the cheapest group of funds beat the average over a 10-year period, while one-third of the funds in the second-cheapest group did so. But just 19% of the funds in the most expensive group managed to beat the average.

Of course, a fund's expenses reflect not only its fees, but also its size. Since funds with smaller asset bases have fewer shareholders to shoulder their fixed costs, their expenses will likely be higher. As a result, smaller funds are more likely to perform poorly, given their cost disadvantage. And there's a much greater chance that poorly performing funds will be closed or merged with other, better-performing funds.

The be-all and end-all?
On the surface, these findings would seem to make sense. After all, fees eat away at investor returns. Of course those funds that devote fewer dollars per fundholder to expenses will generally post better performance! But while fund cost is one of the most important things to look for in your mutual fund search, it's not the only thing. Cheap funds can still underperform the market. Even in Morningstar's own data, more than half of the cheapest group of funds failed to beat their category average over a 10-year period. Clearly, cheapness alone doesn't guarantee success.

Besides examining costs, seek out funds with longstanding managers or management teams. Ideally, managers should have experience in both good and bad market environments, giving you an idea of what to expect from them no matter how the market performs. You also want a fund with a consistent investment process stretching back several years. Stay away from funds that change their stripes every few years in an attempt to catch on to the hottest investing style. Inexpensive funds should be a crucial aspect of your mutual fund search, but don't make cost your only criterion.

Where to look
Take some time to learn about the hundreds of inexpensive funds out there. If you're at a loss, Vanguard is a great place to start. The index-fund pioneer offers many high-quality funds, both index-based and actively managed, that boast some of the cheapest expense ratios around.

If you're in the market for exchange-traded funds, check out some of the broader-market ETFs, such as SPDRs (AMEX: SPY  ) , iShares Russell 1000 Index ETF (NYSE: IWB  ) , or the Vanguard Total Stock Market ETF (NYSE: VTI  ) .

Similarly, a broad-based small-cap ETF like the iShares Russell 2000 Index ETF (NYSE: IWM  ) gives you quick exposure to companies such as Myriad Genetics (Nasdaq: MYGN  ) , Piedmont Natural Gas (NYSE: PNY  ) , and Flowers Foods (NYSE: FLO  ) .

Mutual fund fees are an extremely important part of finding a great fund, so make sure you're not overpaying for yours. If you are, you'll likely find another fund that can do a better job at a lower cost. Leave the pricey mutual funds to someone else, Fool. You have better things to do with your money.

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To learn more about which inexpensive mutual funds are right for your portfolio, check out the Fool's Champion Funds newsletter with a free 30-day trial.

This article was originally published Sept. 28, 2007. It has been updated by Dan Caplinger, who owns shares of SPDRs. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy doesn't cost a dime.


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