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The Secret to Better Mutual Fund Returns

By Motley Fool Staff - Updated Apr 5, 2017 at 8:05PM

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It's the bottom line that counts.

When you're looking to buy a new mutual fund, you'll naturally be attracted to the funds that have done the best lately. But while the list of top performers will look much different from year to year, the funds with the best returns over the long haul have one trait in common: They keep their costs down.

It makes a difference
You might think that the idea of choosing lower-cost funds would be obvious. Common sense tells you that every dollar that your fund managers take for themselves is one less dollar you have to invest.

A study by three Ivy League professors sought to prove that idea. Yet when the professors tested undergraduate and MBA students at Harvard and Penn by letting them choose among four otherwise identical index funds with differing fees, the vast majority failed to pick the least expensive option.

That's perhaps easier to understand when you change your perspective. Over short periods of time, it's easy to ignore fees. And it's especially easy when funds are performing well, as you're less apt to notice paying 2% or more in expenses if your fund is up 30% or more in a given year.

Now, though, those expenses are catching up to you. Consider, for instance, the top-performing large blend stock mutual funds over the past 10 years:

Fund

10-Year Annual Return

Expense Ratio

Top Holding

CGM Focus (CGMFX)

18.4%

1.27%

Weatherford International (NYSE:WFT)

Eaton Vance Dividend Builders (EVTMX)

7.7%

1.04%

FirstEnergy (NYSE:FE)

Hartford Capital Appreciation (HIACX)

7.0%

0.72%

General Electric (NYSE:GE)

Principal Investors West Coast (CMNWX)

6.9%

0.83%

Wells Fargo (NYSE:WFC)

Parnassus Equity Income (PRBLX)

6.4%

0.99%

Microsoft (NASDAQ:MSFT)

Mairs & Power Growth (MPGFX)

6.0%

0.68%

Medtronic (NYSE:MDT)

Manning & Napier Pro-Blend (EXHAX)

5.4%

1.12%

Google (NASDAQ:GOOG)

Source: Morningstar.

You'll notice that just one of the funds has an expense ratio above the average of 1.26% for the category -- and that one is just 0.01 percentage points higher. A similar look at the funds at the bottom of the barrel showed nine out of 10 with above-average expenses, including six over 2% and one over 3%.

You can't afford it
Unless you've got more money than you know what to do with, paying 2% or more in fees is a drag on your portfolio that you just won't be able to overcome. If you invest $1,000 today in a typical stock fund that earns 10% before accounting for expenses, the difference between paying 1% or 2% is huge -- and just gets larger over time.

Length of time invested

Paying 1% expenses

Paying 2% expenses

5 years

$1,539

$1,469

10 years

$2,367

$2,159

20 years

$5,604

$4,661

30 years

$13,268

$10,063

Can you afford to give up that much return? With rising retirement costs, college tuition inflation, and basic everyday living expenses going up, every penny you can keep will help.

To get better returns by reducing your fund costs, you've got two choices. Low-cost index funds give you cheap exposure to the market, with expense ratios as low as 0.1%. But if you agree with Motley Fool Champion Funds expert Amanda Kish that the best fund managers can consistently beat the market, paying a little more for a manager isn't necessarily bad. Just keep an eye on your fund's performance, and make sure that your managers are earning the money you're paying them.

Check out these articles to learn more about:

CGM Focus is a Champion Funds selection. Find out more about the Champion Funds philosophy by looking at our monthly issues, in-depth commentary and analysis, and fund recommendations. A free 30-day trial will get you on the right path.

This article was originally published Dec. 26, 2007. It has been updated by Dan Caplinger, who owns shares of GE. Microsoft is a Motley Fool Inside Value recommendation. Google is a Motley Fool Rule Breakers selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy keeps no secrets.

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Stocks Mentioned

Microsoft Corporation Stock Quote
Microsoft Corporation
MSFT
$291.91 (1.70%) $4.89
Alphabet Inc. Stock Quote
Alphabet Inc.
GOOGL
$121.68 (2.39%) $2.84
Wells Fargo & Company Stock Quote
Wells Fargo & Company
WFC
$45.94 (1.52%) $0.69
General Electric Company Stock Quote
General Electric Company
GE
$79.93 (1.30%) $1.03
Medtronic plc Stock Quote
Medtronic plc
MDT
$94.82 (0.83%) $0.78
FirstEnergy Corp. Stock Quote
FirstEnergy Corp.
FE
$40.83 (1.90%) $0.76

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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