We all know the worn out financial services industry mantra, "past performance does not guarantee future results." It's a good general caution but that disclaimer doesn't stop anyone from making decisions today based upon yesterday's performance.
The problem is that we don't invest backward; we invest forward and there is more to analyzing a mutual fund than reviewing past performance. In fact, the best indicators of future performance include factors many investors overlook. There are other important factors, such as manager tenure, expense ratio, turnover ratio, and tax efficiency to analyze and compare before buying a mutual fund:
If you are going to analyze historic returns, you need to do it right. Past performance does not guarantee future results but it does matter when analyzing actively-managed funds. However, many investors get caught in the trap of chasing performance by constantly buying the funds that are performing best and selling the ones that are performing worst. This is just another form of market timing that insures an investor will be constantly buying high and selling low--the opposite of wise investor behavior. When analyzing past performance, focus more on the 5-year and 10-year returns because these time frames are a greater indication of a fund manager's skill in navigating the ever-changing economic environment.
If you are attracted to a mutual fund's 5-year and 10-year returns, it could be a mistake to buy shares of this fund if the manager has only been at the helm for one year. This indicates the past manager is responsible for the strong long-term performance but the new manager has not proven him or herself. Similarly, you wouldn't dismiss a fund if the 10-year returns look poor, compared to other types of funds, if the 5-year performance looks good and the manager tenure is 5 years. In this case, the current manager should receive credit for the 5-year returns but not receive blame for the 10-year. In summary, be sure that the time periods you are analyzing coincide with the current manager's tenure. You may also want to completely avoid funds with manager tenure less than 3 years.
Low expenses give a fund a head start against similar funds with higher expense ratios. In different words, higher relative expenses are a drag on performance. For example, all other things being equal, a mutual fund with an expense ratio of 0.50 has a powerful advantage over a comparable fund with an expense ratio of 1.00. If both funds had gross returns (before expenses) of 10.00% in a given year, the first fund would have a net return (after expenses) to the investor of 9.50% and the second fund would have a net return of 9.00%. Small savings turn into large savings over time. Granted, a fund manager can produce strong results over short periods of time (less than 5 years) with high relative expenses but this out-performance is difficult to achieve consistently over longer periods of time (more than 5 years). This is why investors choose index funds: Expenses are low and long-term returns tend to average higher than a majority of actively managed funds.
The turnover of a fund represents the percentage of the fund's holdings that have been replaced during the previous year. For example, if a mutual fund invests in 100 different stocks and 50 of them are replaced during one year, the turnover ratio would be 50%. Turnover is related to expense ratio because high relative trading (buying and selling) translates into higher expenses, such as trading commissions and research costs. A low relative turnover ratio also indicates a "buy and hold" investment philosophy, which is generally preferred for long-term investors and indicates conviction on the part of the fund manager, as opposed to an excessive market timing strategy, which can yield strong short-term returns but increases downside risk. Keep in mind the apples-to-apples rule here and compare funds to their respective category averages because some funds, such as bond funds, will naturally have high turnover than most other fund types and categories.
Lower taxes usually translates to higher returns because you are keeping more of your money and earning interest on it while you hold the investment. Most investors have at least one tax-deferred account, such as an IRA, 401(k), 403(b) or annuity, but if you have an individual or joint brokerage account, you generally need to find mutual funds that do not generate too much of a tax burden from dividends and capital gains distributions. For this reason, you may want to steer clear of dividend mutual funds and bond funds in your regular brokerage account, if possible. You can place these funds in your tax deferred accounts. This strategic maneuvering and dividing funds into various accounts based upon tax efficiency is called asset location.
All of the above guidelines for analyzing mutual funds are primarily for selecting actively-managed funds. However, the analysis process for passively-managed funds is almost unnecessary, primarily because index funds naturally have low expense ratios and low turnover ratios and the manager tenure is not generally a consideration. When analyzing index funds, you'll want to be sure the expense ratio is low because low costs are the primary advantage of this fund type. For example, the best S&P 500 Index Funds are also among the lowest cost index funds. If you will only use index funds, you may want to open an account at Vanguard Investments, where you'll find the best overall selection of index funds and ETFs available in one fund place.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.