So you want to invest in mutual funds? That's an excellent idea, because they have a lot to offer those of us who are looking to build fatter retirement accounts. You'll need to find the best mutual funds for yourself, though, and there are thousands on the market. Here's how you might assess the field.
Advantages of funds
First off, let us count some of the ways that mutual funds are wonderful. For starters, not all of us have the time, skill, or interest to study the thousands of stocks out there and select which ones to invest in, or to follow them enough to know just when to sell. So it's great that mutual funds are managed for us -- either actively, by having financial pros study investments and make the buy and sell decisions, or passively, by simply tracking broad indexes and buying whatever those indexes hold.
Funds also offer diversification, exposing us to a lot of investments at once. If one or two head south, the fund will be bolstered by others that hold steady or appreciate. Note, too, that many exchange-traded funds, or ETFs, offer the benefits of traditional mutual funds and a few additional advantages, such as lower fees and no minimum investment amount beyond the cost of a single share.
It's tough to beat the index
As you ponder which funds to invest in, you might make it easy for yourself and simply buy a broad-market index fund, as these have routinely outperformed their actively managed counterparts over long periods. The SPDR S&P 500 ETF (NYSEMKT:SPY), Vanguard Total Stock Market ETF (NYSEMKT:VTI), and Vanguard Total World Stock ETF (NYSEMKT:VT) are such funds, offering, respectively, 80% of the U.S. market, the entire U.S. market, and just about all of the world's stock market. Each offers diversification, dividends, low fees, and market-tracking performance.
That's hard to beat, and even superinvestor Warren Buffett has recommended index funds for most investors.
Traits of better funds
Still, you may want to aim for higher returns by trying to pick funds that stand a chance of beating the odds and outperforming their respective benchmark indexes. If so, here are some traits to look for.
Of course, you should examine a fund's track record -- but do so carefully. A five- or 10-year average annual return well above the index's will look great, but at Morningstar.com, and at most funds' websites, you can look up each year's return for a number of years. Note any extra-good or extra-bad performances, as those will skew the average.
Fees should be a major concern, because they're generally what cause many funds to underperform indexes. Look for low fees and, ideally, no sales load. To put this in context, the average expense ratio, or annual fee, for stock funds was 0.74% in 2013, and it has been falling significantly for a number of years. A decade earlier, for example, it was 1%. For actively managed funds, the average in 2013 was 0.89% versus about 0.12% for index funds. (The average expense ratio for actively managed bond funds was 0.65% versus 0.11% for bond index funds.)
Another number to check is the turnover ratio, which reflects how actively a fund's managers are buying and selling stocks. In general, the lower the turnover ratio, the better. A fund with high turnover might do just fine, but studies have found that lower rates are associated with higher-performing funds. It makes sense, because longer holding periods can reflect more confidence on the part of managers, as well as more patience -- a key trait of successful investors. Frequent trading is also undesirable because it racks up trading costs that shareholders must bear.
It's also worth taking a look at the tenure of the fund's managers. You might find a fund with a solid track record, but if its talented manager has moved on and there's a new person at the helm, that track record may have less value. (You might, of course, also look into the record of the new manager.)
Looking for the best mutual funds isn't rocket science -- but remember that simple, inexpensive index funds are a fine choice for ordinary investors.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.