The Secret to Picking a Mutual Fund

By Markets Fool.com

The entry of hordes of mediocre funds posturing as informed managers. -- Eugene Fama and Kenneth French

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There are many ways to characterize the growth of the mutual fund industry, some of them (see above) much less flattering than others. As an investor, the sheer quantity of funds, styles, asset classes, and of course ratings makes the issue even more confusing. How are you supposed to invest your money when you have such a mind-numbing list of options?

Turns out, there's a surprising fund-picking strategy that you can use to find great mutual funds.

Find the contrarians
We all know that the foundation of smart investing is to buy low and sell high, but actually accomplishing this in any kind of consistent way is truly, well, hard.

However, a recent study reveals that some mutual funds are quite good at it. Their secret? Investing against the grain.

The researchers looked at all the actively managed mutual funds in the U.S. from 1995 to 2008. Contrarian funds were characterized based on their holdings and trading activities -- the study identified funds that made large trades that ran counter to what most mutual funds were doing at the time.

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Even though these contrarian funds don't really look like each other or anyone else, it was found that they have a persistent habit of beating other mutual funds. They have higher alphas and inflows, better performance, and a higher chance of being rated a "star fund."

Why are they so good?
Contrarian funds tend to be larger and trade less, which reduces expenses and thus benefits performance. They also get a little lift by providing liquidity to all the "herd" mutual funds by selling when everyone else is buying, and buying when everyone else is selling.

But those factors aside, contrarian funds just seem to be better at stock-picking. By the researchers' calculations, the most contrarian funds tend to outperform the least contrarian funds, and their better performance is consistent on an annual basis.

How does that work? Part of the value of contrarian investing lies, of course, in its "value" nature. If you buy an unpopular stock, it's likely to be cheaper than the hot stocks, right? But it's not just about price. Researchers find that the contrarian stocks tend to be less liquid, have lower levels of financing and investment, and enjoy greater operating efficiency than the "herd" stocks.

They also typically have "lower earnings momentum, higher information uncertainty, and lower accounting profitability." Those features might make you raise your eyebrows, but for an informed investor who knows the "real" value of a stock, they represent an opportunity to buy for cheap -- kind of like the way Foolish investors like to do it. After all, these guys are experts, and their success indicates that they are able to differentiate the stocks that are unpopular for a reason from those that are just bad stocks.

So, what does this all mean for you?

It means you could conceivably pick your actively managed funds simply by looking at what they're holding. Find a bunch of unpopular stocks in a mutual fund's portfolio, and you may just have yourself a winner.

The article The Secret to Picking a Mutual Fund originally appeared on Fool.com.

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