Successfully finding and keeping up with the best stocks takes a lot of time and talent. For those who lack either one (or both), mutual fund investing is a terrific (and profitable!) answer to the question of how to achieve better financial performance. "But what is a mutual fund?" you might ask. Well, read on for the answer, and then learn how to make a smart mutual fund purchase or two. Your portfolio will thank you.
What is a mutual fund?
Mutual funds, in general, are the pooled investment dollars of many people, who pay a fee to have their funds managed professionally. The fact that your hard-earned dollars are being invested by people who have studied finance is the obvious plus. So is the fact that even with a small investment, you can be instantly diversified, with your assets spread across dozens or even hundreds of stocks and/or bonds or other securities.
A mutual fund's collection of securities is its portfolio, and those who have invested in it are its shareholders. Some funds close to new investors when their managers feel that the fund has grown sufficiently large. After all, more and more money means the managers will have to find more securities to invest in and they may no longer be able to focus on their best ideas.
What kinds of mutual funds are there?
A key distinction between many funds is that some are actively managed and others are passively managed. An actively managed mutual fund will typically have a team of professional money managers who study the universe of securities they might invest in, choosing the most promising ones. They decide when and how much to buy -- and when to sell. Shareholders are paying for their expertise.
Passively managed funds, meanwhile, require little professional tending. They're based on existing indexes (generally stock or bond ones) and simply aim to hold the same components in the same proportion, in order to achieve the same returns (less fees). Such "index funds" have much lower average expenses and fees and studies have found that over long stretches, stock index funds tend to outperform the majority of managed mutual funds. According to the folks at Standard & Poor's, for example, as of the end of 2015, fully 83% of all domestic stock mutual funds underperformed the S&P 1500 Composite Index over the past 10 years. And 82% of large-cap stock funds underperformed the S&P 500.
Mutual funds have many different kinds of focuses. Some invest just in stocks, others in bonds, and some in a variety of asset types. Stock-centered ones are often referred to as "equity" funds, and they can focus on small, medium-size, or large companies. Some seek income through dividend-paying companies (such as via common stocks, preferred stocks, and real estate investment trusts (REITs) and they're referred to as income funds. Others focus on interest-paying securities (such as T-bills, bonds, and notes) and are referred to as "fixed-income" funds. "Balanced" funds will typically feature both stocks and bonds.
"Growth" funds seek fast-growing stocks, while "value" funds look for undervalued gems. Some mutual funds specialize in one industry (such as financial services, utilities, or healthcare) and others in a region (such as China, Brazil, emerging markets, Europe, Asia, or Latin America).
Some funds are above average in their complexity or risk. For example, some funds look for stocks that the managers think will fall, and then bet against them. Some use leverage aggressively, aiming to turbo-charge returns but also turbo-charging risk.
How find the best mutual funds
Once you know you want to engage in mutual fund investing, don't just look for the funds with the heftiest returns. Of course, you must review a fund's track record. But do so carefully. A fat five- or 10-year average annual return will look great, but at Morningstar.com (and at most funds' websites), you can look up each year's return for a number of years. Remember that any extra-good or extra-bad performances will skew the average.
Pay a lot of attention to fees. After all, they're what make many funds underperform indexes. Favor low fees, and, ideally, no-load funds (loads are sales fees). For some context, know that the average expense ratio (the annual fee) for stock funds was 0.68% in 2015, and it has been falling significantly for a number of years. A decade earlier, for example, it was 0.91%. For actively managed funds, the average in 2015 was 0.84%, versus about 0.11% for index funds. (The average expense ratio for actively managed bond funds was 0.60%, versus 0.10% for bond index funds.)
Another number to check is the turnover ratio, which reflects how actively a fund's managers are buying and selling stocks. In general, the lower, the better. A fund with a high turnover might do just fine, but some studies have found lower rates associated with higher-performing funds. It makes sense, since longer holding periods can reflect more confidence on the part of managers and more patience – a key trait of successful investors. Frequent trading is also undesirable because it racks up trading costs that are passed on to shareholders.
It's also worth considering the tenure of the fund's managers. You might find a fund with a solid track record, but if its current manager is new, the track record isn't so meaningful. (You might, of course, look into the record of the new manager.) As you research mutual fund companies, you might run into some boasting that their employees or money managers have significant stakes in their own funds. That bodes well, aligning the interests of shareholders and fund managers.
What are your next steps in mutual fund investing?
So -- what now? Well, you can use the tips above to hunt down top mutual funds. The best ones, after all, stand a chance of outperforming their benchmark indexes. But there's no shame -- and plenty of logic -- in sticking with index funds. Many of those professional money managers don't have such impressive records, after all, because of hefty fees or management issues such as poor investment choices or a counterproductive focus on short-term results -- and it can be difficult to know which funds will be the long-term standouts.
Consider investing in one or more inexpensive broad-market index funds, which are likely to outperform most other mutual funds -- for example, the Vanguard S&P 500 index fund (NASDAQMUTFUND:VFINX). Exchange-traded funds (ETFs) can also serve you well. They're much like mutual funds, but trade like stocks, letting you invest with very few dollars. Some strong candidates are the SPDR S&P 500 ETF (NYSEMKT:SPY), Vanguard Total Stock Market ETF (NYSEMKT:VTI), and Vanguard Total World Stock ETF (NYSEMKT:VT), which will will have you invested in, respectively, the largest 80% of the U.S. market, the entire U.S. market, or just about all of the world's stock market. Each offers diversification, dividends, low fees, and market-tracking performance.
Selena Maranjian has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.