Look at the mutual fund ads that have BIG, BIG headlines screaming out, "The Bullish Global Wisdom Fund is the No. 1 Fund Over the Past Year!" Somewhere under the big headline, in very fine print that is best read with an electron microscope, is the truth: "Past performance is not indicative of future results." Ah, the devil is always in the details, or the small print, in this case. It's true -- past performance on its own is definitely not indicative of future results.
Far and away, the most important item to understand before buying (or before deciding to keep) any mutual fund is the total cost associated with it. This has been hard to do because most mutual funds go out of their way to avoid telling you just how much you're paying to own them. Things are getting easier, though: With the Internet, anybody can now figure out in a matter of moments just how heavy the charges in any mutual fund are.
There are two sets of costs to keep in mind -- the costs of buying and the costs of owning. Here's a piece of Foolish advice: You're best off keeping the costs of buying at zero and keeping the costs of owning as low as possible.
The costs of buying are the sales charges and are usually called "loads." Don't buy funds with any loads. Load funds are ones that charge you anywhere up to 8% of your money right off the bat. Never pay a load. Some loads are "front loads," and some are "back loads," and some are called "contingent deferred sales loads." When we figure out what all the others are called, we'll tell you. In the meantime, just remember to buy absolute 100% no-load funds.
The next step is to make sure that you understand all the annual costs of owning a fund. Cumulatively, these costs are known as the "expense ratio," and they are expressed as a percentage of the fund's assets that go into the pockets of the fund managers and salespeople each and every year. The expense ratio for the average equity mutual fund has moved up from about 1% per year 30 years ago to 1.6% today. We recommend selecting funds that have expense ratios below 1%.
Index funds, of course, have the lowest expense ratios and are therefore the only funds that Fools like. But remember that not all index funds are created equal. While the Vanguard S&P 500 Index Fund has an expense ratio of 0.18 percent, the Merrill Lynch S&P 500 Index Fund charges 0.63 percent (yeeoooowch!) for the exact same service.
The other reason we like index funds is that they beat 75% of actively managed funds. Of course, there's that 25% that beat index funds. If you'd like to learn about those funds that sport low costs and high potential, check out our latest newsletter, Motley Fool Champion Funds.