How to evaluate mutual funds to boost your returns


I'm a bit of a nut about Christmas; I even have a daughter named Noelle. So this time of year can be a bit of downer for me. The tree gets disassembled, the Bing Crosby CDs get packed away, and the holiday cards stop coming. Regarding that last one, however, the void in my mailbox will soon be filled by a different type of tiding — in the form of annual statements from my investment accounts.

OK, so they're not as jolly as cards with pictures of friends and relatives. But using your year-end statements to give your portfolio a thorough checkup can pay off, especially if you discover ways to increase your chances at higher returns. To see the potential benefit, check out this table, which shows how much $10,000 could amount to, given different rates of return and time periods. As you can see, earning another two percentage points a year can add thousands of dollars to your net worth.

Annual Return5 years10 years15 years20 years
6%$13,382$17,908$23,966$32,071
8%$14,693$21,589$31,722$46,696
10%$16,105$25,937$41,772$67,275

Alas, you can't just snap your fingers and pump up your returns. Most investments involve taking on risk, which many people think of as volatility — the ups and downs you'll experience — but I prefer to think of it as uncertainty, as in you generally don't know exactly how an investment will perform, which can make things like retirement planning a bit of a challenge.

Still, there is a way to increase your chances of earning higher returns: Replace your lagging mutual funds. It is not guaranteed to juice your returns, but the evidence suggests that there are some common characteristics of funds that tend to outperform most others with similar investment objectives.

So as you review your year-end statements, keep these suggestions in mind:

1. Consider replacing actively managed funds with index funds

As I recently wrote, approximately 70 percent of actively managed funds (those who pay actual people to pick the investments) underperform comparable index funds (which just copy a market barometer such as the S&P 500). In 2014, the failure rate was even higher, making last year one of the best for index funds in decades.

2. Focus on costs

The evidence is clear: Lower-cost funds tend to outperform higher-cost funds. In 2010, Morningstar analyzed how much expense ratios and the company's proprietary five-star fund rating system predicted a fund's ability to outperform its peers. The conclusion: “If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds…. Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.” This explains a good deal of the secret sauce of index funds — the average actively managed fund has an expense ratio 10 to 15 times higher than that of a comparable index fund.

3. Compare apples to apples

If you just listened to the headlines, you would think that 2014 was a great year for investors. After all, the S&P 500 and the Dow Jones Industrial Average reached all-time highs. However, those indexes focus mostly on large companies in the U.S. – Apple, General Electric, Johnson & Johnson, and so on. Such types of investments outperformed most others last year. So if you compare, for example, a smaller-company fund to the S&P 500 or Dow, the fund will likely look like a laggard. But that doesn't mean you should get rid of the fund. In fact, historically, small-cap stocks have outperformed large-cap stocks over the long term; it just doesn't happen each and every year. So you should instead compare the fund to other small-cap funds to see if it's worth keeping.

4. Compare apples to pommes — that's French for “apples” — carefully

Last year, the U.S. stock market outperformed the markets of all other developed countries, which collectively were down 3.9 percent, compared to the S&P 500's gain of 13.7 percent. Standard & Poor's tracks the performance of 48 global stock markets, and 30 of them were down in 2014.

Thus, the more money you had in an international stock fund last year, the more likely that your portfolio didn't match the S&P 500 — even if it is a good fund. Consider the performance of Dodge & Cox International, which was essentially flat last year. If you anchored on the S&P 500's double-digit return, you might conclude that the Dodge & Cox fund stinks. But its whopping 0.1 percent return actually placed it in the top 9 percent of large-company foreign funds in 2014, according to Morningstar. Since most other international funds lost money, making a teeny-tiny profit was exceptional.

You may be wondering, “Does this mean I shouldn't invest in international stocks?” Nope, at least not in my opinion. There will be times when non-U.S. stocks triumph, such as most of the first decade of the 2000s. It would be grand if we could predict which investments will perform the best from year to year, but history shows that it is impossible. The solution for most people is to have a very diversified portfolio — which includes stocks of all sizes from around the world — so that when one investment is down, another is up, or at least not down as much. However, the “down” part is part of the deal. One of my favorite quotes comes from Pittsburgh-based financial advisor Louis Stanosolovich: “If you're not losing money somewhere in your portfolio, you're not diversified enough.”

The nuts and bolts of comparing those apples

The best place to analyze your funds is Morningstar.com, which ranks a fund's performance relative to other funds with a similar investment objective. Enter the fund's five-letter ticker in the “Quote” field at the top of the site, then click on “Performance” and scroll down to the “Rank in Category” row in the “Trailing Total Returns” box. The lower the number, the better. For example, a 6 would indicate that the fund's performance ranks among the top 6 percent of funds that invest in similar types of assets.

As you size up your funds, keep these in mind:

  1. Look beyond the one-year return to the five-year return or longer.
  2. Just because a fund finished in the top half or even top quarter of other funds doesn't necessarily mean it beat a comparable index fund.
  3. A significant chunk of top-performing funds in one period doesn't duplicate their top-ness during the subsequent period. But performance is still worth considering if you are looking to replace a high-cost, low-performing dud, especially if a low-cost index fund isn't available as is often the case in employer-sponsored plans such as 401(k)s.
  4. While taxes should rarely be the primarily reason for holding on to a bad investment, you should still be aware of the consequences if you are selling a fund in a taxable account.

Best of luck, and here's to better-faring funds in 2015!

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Beth
Beth
5 years ago

Thank you! I’m bookmarking this post for future reference.

Any day now, Canadian banks will start pushing RRSPs and guess which investment vehicle they often favour? I’m aiming to think beyond mutual funds when I do my RRSP and TFSA top-ups.

Mr. Frugalwoods
Mr. Frugalwoods
5 years ago

“If you’re not losing money somewhere in your portfolio, you’re not diversified enough.”

Hah, very true!

One of the things I like about holding extremely broad index funds is that comparing them is not really worth it, except on the metric of fees. One total market index fund at .05% is the same as another.

Johanna
Johanna
5 years ago

Don’t points 1-4 essentially negate the rest of the article? If you’re already investing in low-cost index funds, and you already recognize that different segments of the market (or different parts of the world) go up and down at different rates, what exactly do you stand to gain by evaluating your funds by their past performance? If two index funds had significantly different performance over the past 5 years, it’s either because they have vastly different cost ratios, or they track different parts of the market. If you’ve already minimized the former, and you realize the futility of chasing returns… Read more »

Robert Brokamp
Robert Brokamp
5 years ago
Reply to  Johanna

Hi, Johanna. Those are good points, especially the one about not all index funds being the same (a topic for another post!). Even index funds/ETFs that ostensibly track the same market segment might have different results. One example: an index fund that tracks the Russell 2000 small-cap index vs. one that tracks the S&P 600 index of small caps. As I hinted at in the post, not every investor has a choice of several index funds. A huge amount of workers’ assets is tied up in 401(k)s/403(b)s/etc., and while many have an S&P 500 index fund, most don’t also have… Read more »

Grace @ Investment Total
Grace @ Investment Total
5 years ago

Awesome post. Knowing the past performance of mutual fund will help you determine if it is a good find or not. Mostly, the equity type of mutual fund tend to perform well for medium to long term.

@Derrick_Horvath
@Derrick_Horvath
5 years ago

I think the stat for an even longer time-frame is something like 96% of actively managed mutual funds don’t beat the performance of the S&P. If you are not ready to play the game just put your money in an index fund S&P 500. I actually wouldn’t even waste time getting any more diversified than that, that means you own 500 of the biggest US companies which most have international exposure anyway.

M
M
5 years ago

Thanks for this – especially the point about international investing. As a Brit, we get a lot of investment things from the US, but less so from Europe, even though Germany is one of our biggest trading partners. However, it’s really important to consider how various regions are doing in the world economy and how they measure and report things in case of any regional differences.

Also, love your first point about switching to more passive forms of funds – this is what I’ve done for retirement.

Best Wishes for 2015!

M from There’s Value

Emily @ Simple Cheap Mom
Emily @ Simple Cheap Mom
5 years ago

This is something we’ll be looking atsthis month. We don’t have many investments, but they’re all in high cost funds.

Linda Vergon
5 years ago

(This comment came from Dale, a reader of our daily newsletter.)

Dear Get Rich Slowly:
I can’t even get the $250 to start a “Binary” Source Fund much less $10,000. After all, I’m only 50, but Disabled due to a head-on car accident back when I was 20. My wife, Tami, who was also in a different car accident about 27 yrs ago, and I are living below poverty and just get by month to month.
I find a lot of negative reviews about “Binary Funds”, can you tell me anything?

Emily
Emily
5 years ago
Reply to  Linda Vergon

Dale, I am very sorry to hear of your and your wife’s misfortune. If you have no cash savings or spare income with which to invest, then it sounds like you and your wife might want to focus on building an emergency fund first. Not an investment fund, but a rainy-day fund in case yet another disaster strikes so that you won’t have to rely on credit. There are many good articles in this site –search “emergency fund” to find them. They will discuss how to squeeze out extra money for your fund, where to put it (most recommend something… Read more »

Mike Sidwell
Mike Sidwell
5 years ago

One thing investors will also have to consider when evaluating mutual funds is their expense ration, over time those costs really add up

Kalie
Kalie
5 years ago

Very informative. I agree index funds are the way to go.

Beard Better
Beard Better
5 years ago

It’s not sexy, but my plan for non-taxable accounts has always been to just go with Vanguard’s Total Stock Market and Total Bond Market indices, changing the relative allocations as I get older. Accounting for the restriction of a retirement plan with limited (often expensive) funds was something I hadn’t considered before.

Great article, it has really led me to do some deeper thinking.

Beard Better
Beard Better
5 years ago
Reply to  Beard Better

Whoops, I of course meant “taxable accounts”.

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