Most of us just don't have the time, interest or skills to dig through an entire universe of stocks in search of the best performance. Instead, we welcome having financial professionals manage our money for us via mutual funds -- or having the market itself do the heavy lifting via index funds.
But if you're going to invest in funds, do so carefully. Learn how they make their money (fees!), and how they're managed. To find superior funds, look for:
- Low fees.
- A strong, market-beating track record -- a fund needn't beat the market every single year, but over the long run, it should outperform.
- Managers that have been at the helm for a while, not just a year or two.
- Low turnover and a relatively concentrated portfolio. A fund with hundreds of holdings suggests the managers aren't as committed as those who run a fund with just a few dozen holdings.
And one more thing...
Here's a twist that might be new to you: A fund you're looking at, or already invested in, may be employing "soft dollars" in order to charge you more without your knowing it.
Suppose we've got two entitites, Boffo Brokerage and Super Fund. Super Fund places a lot of its trades through Boffo, and it's charged a few pennies per share for each of those trades. But Super Fund also needs data for research, and new computers to help its analysts crunch numbers and pick stellar stocks. If it were to pay for these expenses itself, their cost would have to come out of the fund's expense ratio -- the annual fee it charges its shareholders. So instead, Boffo Brokerage buys the equipment and data for the fund, and charges the fund a higher fee per trade. Now the cost is being borne by the shareholders, who unwittingly pay for the fund's trading costs, since few of us know anything about soft dollars.
Studies have shown
Several studies have examined this practice. Wharton Business School professor Nicolaj Siggelkow, for example, studied thousands of funds and concluded that practices like soft-dollar arrangements do exist, though they're extremely difficult for investors to detect.
Siggelkow found that funds that employed soft dollars also tended to charge higher fees in general. Some fund-industry supporters have suggested that a corresponding decrease in overall expenses compensates for any sneaky fees, but Siggelkow didn't see that happening.
He also found that funds geared toward institutional investors (such as pension funds) shifted far fewer expenses onto shareholders. This suggests that funds may be taking advantage of us smaller "retail" investors, because we're not savvy enough to know what's going on.
Meanwhile, researchers Gregory Kadlec, Roger Edelen, and Richard Evans studied the trading costs of 1,706 funds between 1995 and 2005, and found that the costs of soft dollars exceeded their benefit. Managers tended to make more trades, to the detriment of shareholders.
What to do
Given this information, you have some options. You can ask the fund company of any fund you're interested in if it engages in soft-dollar transactions. You can ask the Securities & Exchange Commission (SEC) to require greater disclosure of such expenses and how they're paid for. (It has been rather ... uh ... soft on the matter in the past.)
Or you can look for fund families that don't use soft dollars. Back in 2004, when the SEC looked at soft dollars, Massachusetts Financial Services (MFS) and Fidelity were among the fund companies that cut back on soft-dollar use. Despite a steep 5.75% load, the MFS Value A (MEIAX) fund has earned an average annual return of 8.8% over the past decade, and top holdings recently included AT&T
If you'd like some pointers toward some top-notch funds, take advantage of a free trial of our Motley Fool Champion Funds newsletter service.
Longtime Fool contributor Selena Maranjian owns shares of Johnson & Johnson and the Fidelity Leveraged Company Stock fund. Fidelity Leveraged Company Stock is a Motley Fool Champion Funds pick. Johnson & Johnson is a Motley Fool Income Investor recommendation. The Motley Fool is Fools writing for Fools.