There's a reason why Vanguard founder Jack Bogle deemed the mutual fund "the finest vehicle for long-term investing ever designed." A good mutual fund can provide broad diversification, market-beating returns, lower risk, and, perhaps most important of all, peace of mind. And unlike investing in common stocks, mutual fund selection doesn't require prior experience, familiarity with financial statements, or much free time.
If it sounds too good to be true ...
Of course, finding a good mutual fund is about as difficult as coaxing a convincing acting performance out of Nicolas Cage. In fact, three out of every four actively managed mutual funds lose to the market each year.
According to Bogle, the number of common stock mutual funds rose from 49 in 1945 to more than 4,200 in 2005. In any other industry, the consumer would benefit from this increased competition. However, mutual fund expense ratios and portfolio turnover have risen over time -- and fund performance has suffered as a result. The only ones who benefit from this trend are the mutual fund companies themselves, who collected about $111 billion in fees last year.
It doesn't have to be this way
Nick Cage may be a lost cause, but good mutual funds do exist, and anyone can find them. At Motley Fool Champion Funds, we urge investors to concentrate on the following criteria to find the best funds the industry has to offer:
1. Spare the expense.
A fund's expense ratio covers management fees and administrative costs. The average expense ratio is around 1% of assets, but a shareholder-friendly shop like Vanguard typically charges a fraction of that amount. When it comes to expenses, the lower the better. Every percentage point you pay is coming straight out of your returns.
And don't overlook the 12b-1 fee, which covers the fund's marketing and advertising expenses. Don't invest in any fund that charges a 12b-1 fee unless you really enjoy watching your fund family's TV commercials.
2. Are you experienced?
Check the fund manager's performance history: Has he been managing money for decades, or are you paying the price while he cuts his teeth? How did he fare in the 2000-2002 bear market? Look for experienced skippers who have honed their skills through both bull and bear markets.
3. Put your money where your mouth is.
Does your fund manager eat his own cooking? The strongest sign that a manager's interests are aligned with shareholders is a whopping chunk of his own cash invested in the fund. You can see your manager's stake in the "Statement of Additional Information," available on the fund company's website.
Sturdy as an oak
These are three of the criteria that we use at Champion Funds to identify the cream of the fund industry's crop. In fact, these three qualities led us to value investing guru Bill Nygren's Oakmark I (OAKMX), one of our favorite large-cap funds. Nygren runs a concentrated portfolio with low turnover and reasonable expenses (1.05%, no loads), and he sticks to his deep-value strategy through thick and thin.
That strategy doesn't always pay off, but in a bear market, Nygren really shines. In 2000 and 2001, Nygren beat the market by 21 and 30 percentage points, respectively. Instead of high-flying Internet companies like Juniper Networks (NASDAQ:JNPR), Nygren was heavily invested in names like H&R Block (NYSE:HRB), Kroger (NYSE:KR), and CVS Caremark (NYSE:CVS). These simple, un-sexy businesses helped Nygren turn a tidy profit even as most mutual funds lost money.
Nygren continues to favor simple, consumer-oriented businesses today. He recently opened positions in Best Buy (NYSE:BBY) and FedEx (NYSE:FDX) and added to his existing Home Depot (NYSE:HD) holding.
Putting it all together
Following these three keys (and a few other criteria) have led us to 40 market-beating funds since Champion Funds launched in April 2004. For the inside scoop on Oakmark I and dozens more of the best mutual funds the market has to offer, click here for a free 30-day trial. There is no obligation to subscribe.
Despite the presence of Nick Cage, Rich Greifner thoroughly enjoyed National Treasure. Rich does not own shares in any of the companies mentioned in this article. Oakmark I is a Champion Funds recommendation. FedEx is a Stock Advisor recommendation, while Home Depot is an Inside Value pick. Best Buy is both a Stock Advisor and Inside Value selection. The Fool has a disclosure policy.
