The Top 7 Characteristics of the Best Mutual Funds

By Markets Fool.com

Before you invest in a mutual fund, you need to know more about it than simply whether it appeared on a best mutual funds list. Although some of the funds that make these lists are undoubtedly good, using them as the sole basis to pick the mutual funds that you will invest in is a mistake. Many best-of lists feature the top-performing funds over a short or specified period of time. In order to find mutual funds that have a chance to be top performers over the long run, you need to dig a bit deeper.

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In recent years especially, index mutual funds that passively mimic the performance of market benchmarks like the Standard & Poor's 500 index have gained in popularity due to their low costs, their investing style, and in many cases, the fact that they outperform many actively managed funds in the same fund category. To choose a mutual fund that is not just popular but also has a better chance of producing long-term results for your portfolio, assess it in terms of the following seven characteristics that the best-performing mutual funds have in common.

1. Low expenses

For any investment vehicle,there are some factors that are within your control and some that are not. An example of a factor that you cannot control is the direction of the stock market.A key factor that you can control is knowingthe expense ratio of the mutual funds that you choose to invest in.

A2010 study by independent investment research firm Morningstar showed the impact of low expenses in fund performanceto be quite significant. In every mutual fund investment category studied, the lowest-cost quintile of funds outperformed the highest-cost quintile by a decent margin.

Similarly, aVanguard studyshowed the impact of differing levels of annual fees on a hypothetical $100,000 initial account balance over 30 years with a yearly return of 6%. After 30 years, the balance in the account would be:

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  • $574,349 with no mutual fund expenses.
  • $532,899 with mutual fund expenses of 0.25%.
  • $438,976 with mutual fund expenses of 0.90%.

The numbers in both studies clearly illustrate the negative impact of mutual fund fees on an investor's returns. When assessing mutual funds, consider prioritizing funds with low or no expenses because they can potentially perform better for you in the long run.

2. Strong fund management

One of Morningstar's key tenets of its medalist rankings of mutual funds is a strong manager or management team. Beyond just the fund manager, top mutual funds also have a solid group of analysts who research the stocks or other investments bought and sold by the fund managers.Additionally, traders help make sure that the fund trades are properly executed.Even for index funds, the underlying manager can have an impact.

The best mutual funds reflect the performance of their managers.The 2015 Morningstar analyst report for T. Rowe Price Mid-Cap Growth included this example of a strong fund manager:

T. Rowe Price Mid-Cap Growth has all the hallmarks of a successful fund and earns a Morningstar Analyst Rating of Gold. Beyond low fees and a strong parent company, longtime manager Brian Berghuis has executed exceptionally well during his 23-year tenure, posting Morningstar Category-topping returns while limiting volatility. He's done that despite running the biggest fund in the mid-cap growth Morningstar Category, maintaining a disciplined investment process that continues to produce peer- and benchmark-beating results.

A manager change in a mutual fund that you hold should be viewed as a huge red flag, and you should watch the fund closely. Learn as much as you can about the new manager and find out if he will be changing the investment process or other factors that have made the fund a success in the past.

3. Consistent investment process

You need to fully understand the costs and the investment strategy of any mutual fundbefore you invest in it.For actively managed funds, look at the fund's investment process. Consider the following questions:

  • Is the fund consistent?
  • Does it differentiate the fund from its benchmark index?
  • What makes it unique and different from other funds (in a positive fashion)?
  • Is this process sustainable year in and year out?

It is important that you are able to understand the fund's investment process and why this process is unique and presumably better than other investment options available to you. If you can't answer the question "Why should I invest my money here?" then the answer is that you probably shouldn't.

4. Strong parent company

Running a mutual fund is a complex proposition that requires more than just a skilled manager to be successful. Having a strong parent company can help with the recruitment of talented support staff. A strong, ethical parent company can set the tone for all of its funds in terms of stewardship, which Morningstar defines as:

  • The manner in which funds are run.
  • The degree to which the management company's and fund board's interests are aligned with fund shareholders.
  • The degree to which shareholders can expect their interests to be protected from potentially conflicting interests of the management company.

A 2014 report by Morningstarnamed four fund families as the recipients of its top stewardship grades -- Vanguard, T. Rowe Price, Dodge & Cox, and American Funds -- noting that they also had been successful in terms of Morningstar's success and risk-adjusted success ratios.

T. Rowe Price has since been featured as an example of a top-notch mutual fund company: "T. Rowe Price has acted in fund holders' interests by closing funds with surging asset bases and avoiding trendy fund launches," reported Chartered Financial Analyst Katie Rushkewicz Reichart for Morningstar in 2015. "Reasonable fees and a manager compensation plan focused on long-term performance are other pluses."

5. Strong relative performance

When looking at mutual funds, investors should compare apples to apples. Comparing the performance of a fund that invests in government bonds to one that invests in large-cap domestic stocks is meaningless. These funds will be different in almost every way.

When judging the past performance of a fund that you are considering buying or one that you already own, look at the fund's performance in the context of its category or peer group of funds. Assess how the fund's trailing three-, five-, and 10-year performance histories rank. In the case of an actively managed fund, find out if the fund's track record was achieved under the current manager.

6. Size of the fund

Size matters when it comes to managing a mutual fund. Over the years, many mutual funds have produced enviable track records in their early years of existence only to see that performance taper off as their reputation grew and new investor money poured in.

Size is especially critical in mutual funds that invest in small- or mid-cap stocks. These stocks havemore limited investment opportunities, and at some point, a fund manager can run out of good opportunities within the fund's investing niche.

Mutual fund companies that are shareholder-centric might close the fund to new investment, which can help. But as the fund grows in size due to its own success, management problems can surface again.

To address growth problems, some funds have transitioned from small-cap funds to mid-cap stocks. Others have just started investing outside of their original investment mandates, and the results of such diversification have been mixed.

The issue of size is not as much of a concern for mutual funds that invest in large-cap stocks or for index funds. Nonetheless, savvy fund investors pay attention to the assets under management for funds and look for any performance drag if the fund gets too big.

7.Differences from the benchmark

For actively managed funds, consider differences from the benchmark. Many large-cap stock funds have been accused of being "closet indexers" in that the composition of their holdings is not that different from that of their benchmark index, which is usually the S&P 500.

Too often these closet indexers underperform the index, and investors pay higher expenses than if they had just bought into an index fund.For example, T. Rowe Price Mid-Cap Growth has provided a higher return with less volatility than the average fund in the mid-cap growth category.

Bottom line: Get to know the fund before you invest in it

Selecting and monitoring top-performing mutual funds is not easy. Whether they're index funds or actively managed funds, review them for the seven characteristics of top mutual funds listed above before investing. Index funds should have ultra-low expenses and track their underlying indexes closely. Actively managed funds need to be monitored for a number of factors.

Of all the factors to consider when reviewing mutual funds, low expenses are always a good starting point. As with any investment you might be considering, it is important to fully understand why a given mutual fund is an appropriate place to invest -- never invest in anything that you don't understand.

This article originally appeared at GoBankingRates.

The article The Top 7 Characteristics of the Best Mutual Funds originally appeared on Fool.com.

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