With thousands of mutual funds out there, all competing for your investment dollars, finding the right fund can be somewhat of a needle-in-a-haystack proposition. For decades, investors have tried to find the magic formula that would predict which funds would outperform the market and their competitors. Now, new data appears to indicate that picking winning funds may be a matter of identifying one simple attribute.
The price is right
According to a recently released study by Morningstar, low expenses are likely to be the best predictor of a fund's future success. Apparently, having a low price tag is more likely to indicate greater future returns -- even more so than having a high Morningstar star rating. As an example, the least expensive 20% of domestic equity funds in 2005 posted average annualized gains of 3.35% over the next five years, compared to average returns of 2.02% for funds among the most expensive 20%. While Morningstar's star rating has been useful in identifying fund winners based on past risk-adjusted performance, it hasn't always been consistent.
So does this mean that finding cheap funds is the key to investment success? Can investors ignore everything else about a fund, as long as it has a low price tag? Well, not so fast. I certainly agree that investors should look for the cheapest fund that will get the job done for them. There's no reason why anyone should pay above-average fees for access to any fund. If you're talking about passively managed investments like exchange-traded funds, fees should be the primary criterion for selection. That's why investing in super low-cost ETFs Vanguard Total Stock Market ETF
Don't miss the forest for the trees
While fees are an extremely important part of determining an actively managed fund's chance of future success, you can't look at cost to the exclusion of everything else. Investors still need a fund with experienced management and a strong performance history in differing market environments.
For example, since the average large-blend fund charges 1.30%, according to Morningstar, an investor may figure that any big-name fund that charges substantially less than that should outperform. After all, you can't argue with the idea that more expensive funds have a higher barrier to surpass. Thus, they need to generate better returns to even match the performance of a lower-cost fund, all else held equal.
But while the pattern may hold in the aggregate, on the individual fund level, it doesn't always measure up.
An investor looking for a low-cost fund may land on an option like Fidelity Growth & Income (FGRIX). With a low 0.78% expense ratio, the fund should do well, since its costs are roughly 40% lower than its average competitor. Unfortunately, that price advantage hasn't translated into better returns here.
Fidelity Growth & Income has fallen behind 97% of its peers over the past 15 years, and it trails the S&P 500 by more than 3 percentage points a year over that time. The fund was caught flatfooted by the financial crisis, slammed by its investments in AIG
Paying for value
On the other side of the equation, take a fund like Jordan Opportunity (JORDX). This large growth fund has only been around for roughly five and a half years, but in that time, it has outpaced the S&P 500 Index by an annualized 5.6 percentage points.
Manager Jerry Jordan takes an aggressive approach to growth investing, turning the portfolio over frequently in the process. Right now, Jordan likes defensive names such as Coca-Cola
The only downside? The Jordan Opportunity fund comes with a 1.42% price tag. That's a bit pricier than the average large-cap fund, but it doesn't have any relation to Jordan's obvious skill as a manager, or to how well investors in the fund have made out so far.
While expenses are indeed a huge factor in determining a fund's future success, you can't consider costs in isolation. Investors should still look for funds that have invested in a consistent manner over time, have a long-tenured manager or management team, and boast a favorable performance track record over both bull and bear market environments. Fees may be one of the most important parts of picking winning actively managed funds, but by combining all the other necessary pieces of the fund selection puzzle, investors can be assured that their money is going to the most deserving fund candidates.
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Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. The Fool owns shares of Coca-Cola, which is a Motley Fool Inside Value and Motley Fool Income Investor recommendation. The Fool has a disclosure policy.