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The Key to Mutual Fund Success

Successful mutual fund 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. And although you should consider many different factors when searching for funds worth keeping, research from fund giant Morningstar suggests that one single factor may best predict mutual fund performance.

Key to success
In its study, 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 over whom to spread their costs, their expenses will probably 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 -- but it does appear to be a necessary condition for success. So while inexpensive funds should be a crucial aspect of your mutual fund search, you shouldn'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. But Vanguard isn't the only good fund company by any means.

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 probably 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.

Price is a very important factor to finding the best fund, but it's not the only one. Next, we turn to the importance of finding a good fund manager.

Read/Post Comments (3) | Recommend This Article (72)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 13, 2010, at 5:13 PM, Fool wrote:

    Good article - very helpful in getting started, investing.

  • Report this Comment On February 20, 2015, at 10:51 AM, mick2360 wrote:

    Good advice. I admit that before reading this series, I was looking mostly at past performance. I'm off to re-evaluate as mutual funds are the only investment that my 403-b plan allows.

  • Report this Comment On July 28, 2015, at 3:49 PM, neilson wrote:

    I was advised by a local asset management firm that reported returns were AFTER deduction of fees. You take the position that returns do not take fees into account. Is this correct?

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