The only reason to own active funds is to outperform the market. That's it, really. If you're just looking for diversification, you're better off buying an index fund.

This is simple advice, but it's well worth remembering. There's more than $10 trillion invested in mutual funds at the moment, and the performance of most funds is not encouraging.

How did funds get so popular?

According to Standard & Poor's, the S&P 500 has beaten 67.4% of large-cap funds over the past five years. And the SmallCap 600 has outperformed 79.2% of small-cap funds over that period.

And you need to be very aware of how mutual fund fees will affect your portfolio over the long term. A recent study shows that a $10,000 investment in a fund with a 0.5% expense ratio would accumulate almost $15,000 more during a 20-year period than a fund with a 1.5% expense ratio. Fees matter. A lot.

All is not lost
Should investors abandon active funds altogether? No; they just need to be choosy when shopping for funds. Here is one possible approach:

  1. Find proven stock pickers.
  2. Look for long manager tenure.
  3. Avoid high fees.

Now, this might be a lot to ask for, but some funds do deliver the goods. For example, the Dodge & Cox Stock Fund (DODGX) has delivered annual returns of 14.2% over the past 10 years compared with 8.4% for the S&P 500. And its current expense ratio is just 0.52%, which is much lower than the industry average of 1.5%. With an average annual tenure for its managers of 23 years, this fund has succeeded by investing in large-cap value stocks, such as:

Company

% of Fund

Hewlett-Packard (NYSE:HPQ)

4.1
Comcast

3.7
Pfizer (NYSE:PFE)

3.3
News Corp. (NYSE:NWS)

3.0

Time Warner (NYSE:TWX)

2.6

Chevron (NYSE:CVX)

2.6

Sony (NYSE:SNE)

2.5

McDonald's

2.4

Matsushita Electric Industrial

2.3

Cardinal Health (NYSE:CAH)

2.3
Company data as of Sept. 30, 2006.

This fund, unfortunately, is currently closed to new investors. But it is the type of fund you should be looking for.

One way forward
Each month, Fool fund guru Shannon Zimmerman offers up a market-beating fund of this sort in our Motley Fool Champion Funds newsletter service. While 75% of funds underperform the market, 90% of Shannon's fund selections are ahead of the market by an average of 11 percentage points.

And Champion Funds owes its success to:

  1. Finding proven stock pickers.
  2. Looking for long manager tenure.
  3. Avoiding high fees.

Abide by those three principles as you hunt for your next fund. And if you'd like to see Shannon's latest picks in addition to his past archive of fund selections, click here for a 30-day free trial. You are under no obligation to subscribe.

John Reeves does not own shares in any of the companies mentioned in this article. Pfizer is an Inside Value pick. Time Warner is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.