The best mutual funds are the ones with the best performance, right? The short answer is yes. But it is wise to invest a few minutes of time in the slightly longer answer.
Past performance is no guarantee of future results … and sometimes it’s not even a factor to consider at all when researching and analyzing the best mutual funds and ETFs.
The prudent investor will look at the greatest contributing qualities to performance a fund possesses now. This can give a better indication of future performance than does past performance.
As I mentioned in my recent story, How to Analyze Mutual Funds, performance can be a good place to begin, but it is crucial for your investing success to dig a bit deeper and find out why the fund performed well over the given period of time.
And thus we have our primary theme: What are the biggest contributing factors that the best funds have in common? What makes them the best in their class? Here are three of those factors.
What the Best Mutual Funds Have in Common: Low Expense Ratio
If you’ve ever done any cash flow analysis or even a basic household budget, you know that the quickest and easiest way to keep more money is to spend less.
The same holds true for mutual funds: Higher expenses are a drag on performance and lower expenses will boost returns. This is especially true over long periods of time.
I looked at all funds that performed in the top 20% or better versus their respective category peers for 10-year annualized returns. That search resulted in about 3,200 funds. I then looked at the 100 funds with the lowest expense ratios and not one of them performed worse than average in their class.
In other words, 100% of the top 100 funds with the lowest expense ratios in the entire fund universe beat their respective category averages.
As you might expect, most of these funds were index funds and many of them were institutional class shares, which have high minimum initial purchases (such as $10,000 or more). But the point remains the same: Expenses matter.
For example, the Admiral shares for Vanguard Mid Cap Index (MUTF:VIMAX) have a rock-bottom expense ratio of 0.09%, compared to the average of 1.24% for the average mid-cap blend fund. The 10-year performance rank for VIMAX places it ahead of more than 90% of category peers.
What the Best Mutual Funds Have in Common: Long Manager Tenure
Although length of manager tenure is not a significant performance factor for passively managed index funds, it may be the biggest factor contributing to the performance of actively managed funds.
In fact, you can often eliminate an actively-managed fund from your consideration if the manager tenure is below 5 years. This time frame is important because managers can capture high returns over a shorter periods of time without much skill if their style has been in favor lately.
For a large sampling of actively managed funds, I performed a search of large-cap growth stock funds and analyzed the top 20% by performance, as ranked by 10-year annualized returns through the end of 2014. The sample came to about 300 funds, and 200 of them had manager tenures of 5 years or more.
So two-thirds of the top large-cap growth funds had manager tenures of at least 5 years. The funds at the top of the list tended to have managers at the helm for 10 years or more.
For example, the top performing large-cap growth stock fund for 10-year returns through 2014 is Alger Spectra Z (MUTF:ASPZX). The fund managers have been running assets for the Alger Spectra funds for more than 10 years.
What the Best Mutual Funds Have in Common: Below-Average Assets Under Management
This is another factor you can ignore with most index funds, but its crucial for the best actively managed funds.
For full disclosure, I have a bias against funds with huge assets under management (see my story on mutual fund asset bloat) but I have good reason: Actively-managed funds that have grown too large in asset size tend to perform more like index funds (and often much worse), in which case you would have been better off with the index fund!
I made a recent case in point in my story on why some of the biggest American Funds are under-performing:
Their biggest fund, which has more than $142 billion in total assets, is American Funds Growth Fund of America (MUTF:AGTHX), which comes in many different share classes (I counted 14 of them).
In 2014, the Growth Fund of America gained 9.5%, which is not a poor return in absolute terms, but the performance is 4% below that of the S&P 500 Index, which gained 13.5%.
In summary, there are almost always exceptions to a general rule, and you’ll often find outliers that defy the statistical averages. For example, there are top-performers with high expense ratios and bottom-performers with low expense ratios.
But if you’re searching for the best mutual funds — the ones with potential to outperform in the future — you’ll look for low expenses in all funds and, for actively managed funds, you’ll also want to see long manager tenure and below-average assets under management.
As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.