Best No Load Funds

The Best Noload Mutual Funds Have VERY LOW Portfolio Turnover

Higher mutual fund turnover means higher securities trading costs, which reduce investment fund performance.

Short-term mutual fund trading is a zero sum game played against other very well informed mutual fund traders and other securities market traders. On average, higher mutual fund turnover is far more likely to result in lower investment fund performance — instead of superior risk-adjusted performance.

Higher stock and bond mutual fund turnover indicates that management is very active in buying and selling. Higher mutual fund turnover indicates a shorter-term strategy to pursue supposedly superior returns. The investment fund manager hopes that his or her short-term speculative insights will allow the fund to beat others in the highly competitive securities markets.

Most often, however, the very active investment fund manager will be wrong about the supposed virtues of more frequent trading. When securities trading volume is greater, then even higher investment fund performance is required just to break-even on the associated incremental securities trading costs.

The primary impact of excess turnover is to drive up trading costs, which tend not to be visible to individual investors. Such trading costs include brokerage commissions, the bid/ask spread, and the market impact, if mutual fund trading causes the bid-ask spread to move temporarily to absorb higher trading volume.

The mutual fund turnover ratio serves as a visible proxy to measure the more hidden securities trading costs of actively managed mutual funds.

Such securities trading costs are not detailed in the information that is easily available to mutual fund investors. Trading costs are not paid out of the management expense ratio of the mutual fund, but instead securities trading costs directly reduce the reported investment fund performance and net asset value of the fund’s securities portfolio.

When compared to funds of a similar style, a fund’s turnover ratio gives a good indication of fund activism. Investment research studies have demonstrated that lower turnover is better.

Certain fund management styles will be characterized by low turnover, such as noload mutual funds that track passive indexes. Certain fund management styles, such as aggressive growth equity or stock mutual funds, will have far higher mutual fund turnover. Unfortunately, the investment research literature does not demonstrate that higher turnover leads to better performance.

In fact, the opposite is true. The great majority of actively managed funds with high turnover do not demonstrate better investment fund performance results, after the additional trading costs are taken into consideration. Furthermore, no reliable way has been shown to identify beforehand the minority of higher turnover funds that will eventually do better. You are far more likely to pick from the majority of higher turnover funds that will do worse — sometimes much worse — because of their added costs.

When you select noload mutual funds, look for funds with the lowest turnover. Very low turnover funds are much more likely to provide superior investment fund performance.

The reason is simple. Low turnover noload mutual funds avoid the additional drag of higher securities trading costs.

The automated application that you use to screen mutual funds should allow you to screen for portfolio turnover. Turnover will usually be calculated as a percentage of the fund’s average portfolio value on an annual basis. Annual percentage turnover could range from a very minor part of 100% to a number that is many times 100%.

For points of reference, Morningstar provides mutual fund turnover statistics for major types of funds. Morningstar data indicates that actively managed domestic stock mutual funds have average turnover of about 100%. Average turnover percentages are similar for international stock funds.

Taxable bond funds had average turnover around 150%. Of course, bond mutual fund turnover can vary significantly due to the average duration of the bonds within the fund. Municipal bond funds typically have much lower turnover of around 25% per year. Over time, these mutual fund turnover averages for actively managed funds may shift.

In contrast, passively managed, stock index noload mutual funds have far lower turnover and therefore far lower trading costs. The best noload stock index funds will have single digit annual percentage turnover ratios or at least very low double digit percentages.

Concerning bond market index funds, these usually are passively managed noload mutual funds holding fixed income securities. Noload bond funds will have turnover that also varies, because of the average duration of the bonds in the fund. Nevertheless, noload bond index funds should almost always have lower turnover, when compared to more actively managed bond mutual funds.

Tags: securities trading costs, noload mutual funds, investment fund performance, mutual fund trading, mutual fund turnover

The Best No Load Mutual Funds Have VERY LOW Investment Management Expenses

A high ETF or mutual fund management expense ratio can only be justified, if an investment fund earns even higher net returns that compensate for these higher expenses.

Sadly, this is most often NOT the case with costly actively managed equity and bond mutual funds and with high cost exchange-traded funds (ETFs). In addition, you have no reliable way to tell beforehand which actively managed fund will return more than its added costs. With a passively managed index fund, you are highly likely to get an investment return that is close to the securities market return less your costs.

A higher management expense ratio will tend to cause an actively managed fund to trail the return of index funds. Therefore, your chances of picking a supposedly superior actively managed fund are greatly reduced. Even in the short run, only a minority of actively managed mutual funds perform well enough to compensate for their higher investment management expenses.

In the longer term, even fewer actively managed stock and bond funds will beat the market, because “superior” short-term performance is mostly due to luck rather than to skill. Luck tends not to last. When the performance evaluation time period gets longer, then there are fewer and fewer actively managed mutual funds with net performance that is better than a passively managed index fund targeting a market return. Actively managed mutual funds are simply not reliable vehicles to plan for your family’s long term financial needs!

The average actively managed mutual fund manager demonstrates some skill, but the added costs swamp this additional investment return.

Certain scientific studies have demonstrated that some professionally managed equity mutual funds seem to exhibit a modest level of apparent skill in their ability either to choose stocks and bonds and/or to manage their stock and bond portfolios. These mutual fund managers may be slightly better stock pickers, and/or they may have better portfolio management practices.

In managing their portfolios, these mutual fund managers may not make the behavioral mistakes that many individual investors do. Examples of behavioral investment mistakes are holding on to losers too long and selling winners too quickly.

Scientific finance studies have demonstrated a very slight persistence in stock price trends for some, but not all equities. This persistence could benefit portfolio managers who hold their winners longer and sell their losers more quickly. Evidence of superior skill for bond fund manager seems entirely lacking, so buying no load bond funds is very clearly a better strategy.

Most professional investment fund managers have expertise, but efficient market competition tends to make them all mediocre in the long term.

Just because scientific finance studies do not support buying actively managed stock and bond funds on a net returns basis, this does not mean that professional money managers are not skillful. To the contrary, the level of professional expertise in portfolio management at most fund companies is very high. However, unlike American schools and colleges, the real-time securities markets have built-in grade and achievement deflators.

On average, the markets deliver C level returns before costs. If your costs are lower, you are more likely to get an A or B. If your costs are higher, you are more likely to get a D or F. The major factor that adds to all the confusion is that market participants must put a current, risk-adjusted value on the future economic prospects of their potential investment holdings.

These highly uncertain predictions make securities market prices highly volatile. After the fact, market participants will eventually be graded on the future value impacts of currently unknowable future events. Some investment fund managers will be lucky, while others will not be in the short run. In the long run, their investment fund manager performance usually averages out.

Minor, short-term skill demonstrated by some active professional investment fund managers, perpetuates the completely spurious active management versus passive management “debate.”

From the perspective of the individual investor, this tired active management versus passive management “debate” or argument is simply and completely irrelevant. Scientific finance studies have the advantage of being done after the fact, and they use large sets of historical investment fund performance data to see what actually did happen. Some studies provide continuing fuel for self-interested industry promoters to keep saying that actively managed mutual funds provide value.

However, without a crystal ball, individual investors instead face the daunting task of trying to pick some of the few future winners out of a very large crowd of investment fund managers who will not provide a positive net return. The active management debate implies that after all the additional management expense ratio costs, mutual fund trading costs, higher capital gains taxes, and extra time are taken into account, investors are supposed to have some crystal ball to sort future winners from losers.

Nobody has such a crystal ball. The closest approximation to a crystal ball that is available is the simple rule to only buy very low cost mutual funds and ETFs. All very low cost mutual funds and ETFs are passive investment funds.

The investment fund management industry keeps pointing to past performance and Morningstar ratings as predictors, when superior past performance and 4-star and 5-star ratings are completely useless predictors. Instead lower costs and lower turnover are far superior predictors of future mutual fund performance.

Even the scientific studies that demonstrate some professional skill, do not show that this incremental skill justifies paying the much higher fees of active funds. On average, actively managed funds simply do not have sufficiently higher returns to cover even their higher direct management expense ratios.

The research shows that added management expense ratio costs typically outweight added performance by about 2 to 1 or 3 to 1. And, this does not even count the higher trading costs and the deadweight loss that individual investors are subjected to when they pay investment sales loads and 12b1 fees!

How is that for an “active” mutual fund or ETF investment return?

Spend 2 or 3 or 4 dollars more to get a dollar back! Waste your valuable time trying to figure out which funds will demonstrate better performance. Take the risk that you could pay far more and still end up picking one of the worst rather than one of the “best” actively managed funds, after the results are in. Do this over and over across your lifetime. Sounds fun, huh?

Did you know that one investment research study on growth mutual funds demonstrated that there was a 12 to 1 ratio between the cumulative returns of the best performing growth mutual fund to the worst performing growth mutual fund over the 19 year period from 1976 to 1994?? (See: Edward S. O’Neal, “How Many Mutual Funds Constitute a Diversified Mutual Fund Portfolio?” Financial Analysts Journal, March/April 1997: 37-46)

Sound ridiculous to you? For the slimmer chance of winning the investment manager selection lottery, do you want to roll the dice and end up with a terrible fund or a series of terrible funds instead? Perhaps this is not the best way to plan your family’s financial future.

Why bother listening to this completely self-serving securities industry “debate,” when you can simply buy very low cost, broad market index mutual funds and ETF, and then get on with your life? Do you really want the pleasure of spending a lot of time in your life listening to one financial advisor after another tell you that a succession of expensive investment funds are “better”? Then, do you want the excitement of watching these “better” funds perform over time, when they are far more likely not to be better as time passes and as your portfolio is harmed?

Furthermore, higher active transactions costs are most often hidden and left out of the comparison, even though higher active fund trading costs can will drag down net returns for higher turnover funds. Also, these studies usually do not account for increased taxes paid by individual investors caused by active trading. Finally, they do not measure the opportunity cost related to an individual investor’s extra time spent on futile, ongoing efforts to pick “superior” funds that most often will not be.

An individual investor is far better served by choosing from among the numerous passive, noload mutual funds and exchange-traded funds that have decided to compete on low costs.

Obviously, a decision rule that focuses on lower fees will strongly favor passively managed index funds over actively managed funds. You will have more choices than you need, if your restrict your investment fund choices to those passively managed mutual funds and ETFs that are trying to attract individual investors’ money by charging very low fees.

When screening mutual funds and ETFs, you should first set a relatively stringent upper limit on the annual expense ratio that you are willing to pay. With passively managed domestic index funds, .5% annually is an overly generous upper limit. Many domestic index funds are available with management fees under .25%. Because of their variety, it is not as easy to generalize about screening international and global index funds. However, much lower management expense ratios should still be the key screening rule for these non-US funds.

With actively managed mutual funds, you first really should ask yourself whether you have a valid reason for still preferring them over passively managed index funds. If you still have a good reason to select an actively managed fund, which most individual investors will not have, then you should still seek lower management expense ratios among active funds. You might start screening with an upper expense ratio limit of .75% and then move lower. Obviously, you should also amortize any sales loads that you cannot avoid. Again, however, there is never a good reason to pay a front end sales load or back end sales load. There are many better noload mutual funds available for you to buy directly from no load mutual fund companies.

Tags: management expense ratio, investment management expenses, passively managed index fund, managed index fund, mutual fund manager, actively managed fund

Avoid Large Actively Managed Mutual Funds

Big mutual fund portfolio positions and higher percentage ownership of any company’s stocks and bonds are not good for actively managed mutual fund performance.

These big positions and high percentages are not good for your personal investment portfolio either. Large size constrains how a fund can trade and how efficiently it can do so. When an actively managed mutual fund becomes very large, it must manage its trading exceptionally well, or it will suffer significantly higher transactions costs, which tend to cause lower net mutual fund performance. The need to balance short term securities market trading supply and demand will drive up trading costs for actively managed mutual funds.

There are some extremely large mutual funds. For example on January 26, 2007, Morningstar, Inc. data indicated that the total net assets of the largest U.S. domestic mutual funds ranged from $161.9 billion for the largest mutual fund to: $45.0 billion for the number 10 US mutual fund, $25.1 billion for #20, $19.0 billion for #30, and $14.3 billion for #40.¹

Only a few of these very large stock and bond mutual funds and ETFs were passively managed no load index funds.

The rest were actively managed mutual funds. All share classes for each fund, including share classes with front end loads and back end loads, were grouped together for these total asset numbers. While exchange traded funds (ETFs) are a much newer investment vehicle than mutual funds, their characteristics are more similar than different.

In general, individual investors can use mutual funds and ETFs interchangeably, if they follow the “7 Ways to Pick the Best Noload Mutual Funds and ETFs” The largest U.S. diversified domestic ETF held $85.1 billion and the 10th largest exchange-traded fund held $10.9 billion.²

Keep in mind that the large investment portfolio size issues and the market impact issues discussed in this article are much more significant concerns for actively managed mutual funds. They are not as important for no load mutual funds and for ETFs that track passively managed market indexes. This is simply because very large index mutual funds do far less trading.

Because of how ETFs are constructed, the ETFs that have been introduced thus far for purchase by individual investors tend to be indexed and therefore more similar to passively managed index mutual funds. Unfortunately, the vast majority of ETFs on the market now track relatively narrow sector index benchmarks. This leaves undesirable industry sector volatility in your portfolio, when compared to broader based market indexes that diversify across all market segments.

The composition of an ETF’s portfolio is transparent and known to the market on a daily basis. Portfolios of actively managed mutual funds are only known publicly a few times a year. Therefore, mutual fund portfolio composition becomes public long after trading changes have been made.

Given this exposure of an active ETF’s trading strategy almost in real time, there is concern that other traders in the market might front run an actively managed ETF. This has slowed the introduction of actively managed ETFs, although some are coming to market. Nevertheless, there already are some ETFs that do reconstitute their portfolios periodically and these ETFs can be viewed as quasi-actively-managed.

With no load index funds, the target composition of their portfolios can be known through the benchmark index.

The composition of a particular no load index fund may vary from the index, but usually only by a small amount. The target portfolio composition changes only when the publisher of the underlying bond or stock market index changes the composition of the index. When the index changes, then index mutual funds must make changes, and this can have a market trading impact. Adverse market impact raises transaction costs and lowers net mutual fund or ETF performance.

Is there a maximum stock and bond mutual fund size of actively managed mutual funds that might affect investors’ welfare negatively?

A larger fund can afford more analysts and can increase the number of different company securities that it holds. However, there are practical limits. The size of the positions held will also tend to increase. Very large size can push some funds into investing only in companies with very large market capitalizations.

Many of these very large funds become defacto index funds, because their holdings tend to replicate a large portion of the benchmark securities index, while they charge higher fees and more often deliver inferior net performance after their added investment expenses and costs.

With so much money to invest, it is not practical for these fund giants to track companies with smaller equity market capitalizations or debt issues. Many giant mutual funds have enough assets to buy smaller companies in their entirety.

However, all diversified investment funds are constrained from doing so by laws and regulations — even if they wanted to so. For example, funds must avoid certain concentrated positions (e.g. not holding more than 5% of a company’s securities) that would jeopardize their legal standing as diversified management companies and their corporate tax exemptions at the fund management company level.

Even if they stay within these legal ownership limits, very large actively managed fund size inevitably increases the fund’s percentage ownership of the securities that it holds. A notable issue faced by very large and by large actively managed mutual funds is the “market impact” of the fund’s trading activities.

If the fund tries to buy or sell large positions in individual firms over short periods, the fund can adversely affect the market price of that security temporarily. When large funds buy or sell, there must be sufficient trading volume on the other side. A sufficient volume of trades by others with contrary opinions of a company’s prospects must be available. If not, the market bid/ask price range must adjust temporarily to encourage others to enter the securities markets to trade.

Trading induced changes in securities prices can significantly drag down the net investment performance of very large actively managed mutual funds.

In addition, mid-sized mutual funds can also suffer adverse market impact. If the positions traded by mid-sized funds are substantial relative to the total available short-term trading volume, they will also suffer negative market impact. Nevertheless, this market impact problem tends to be the more acute with larger funds.

Given these considerations about the size of very large actively managed mutual funds, you might wish to limit the maximum size of the actively-managed mutual fund or quasi-actively-managed ETF, in which you would be willing to invest. You might decide that you are not willing to put your money into funds that exceed perhaps $10 billion or $5 billion in assets or even less. There is no magic excess size threshold. Nevertheless, you should be aware that you can still choose from numerous funds with assets under $10 billion or $5 billion that still meet the other screening criteria from the “7 Ways to Pick the Best Noload Mutual Funds and ETFs.”

Many monster-sized actively managed mutual funds receive heavy publicity.

You should keep in mind that your familiarity with the brand name of a mutual fund or with the names of mutual fund companies does not mean a larger fund is “better” than a smaller one whose name you may not recognize. In fact, because of the problem that investment portfolio performance could be worse for large and very large actively managed mutual funds, well known brand names might deliver worse performance over the long term.

If well recognized actively managed mutual fund brand names attract excessive asset inflows, this will cause higher trading costs, greater “market impact,” and other investment management problems. In addition, the portion of their portfolios held in cash can increase, and you will get charged the same high management expense ratio for the cash, as well as, the stock and bond holdings.

Familiarity or lack of familiarity with a mutual fund brand name should not be considered when you screen funds initially. Brand awareness often is simply an indicator of a fund family’s higher marketing and advertising costs that fund shareholders tend to pay one way or another. If other screening criteria indicate that a fund could be attractive, the fact that it is an unfamiliar fund should have absolutely no bearing on whether you decide to do more investigation of an unfamiliar mutual fund — preferably a no load index fund.

Understand that large mutual fund portfolio size is a far, far greater concern for actively managed managed funds than for passively managed index mutual funds and ETFs that track bond and stock market indexes.

Very large passively managed index funds do far less trading, because they trade only to invest net inflows or to redeem net outflows. In contrast, large actively managed funds incur much higher trading costs in pursuit of better returns, which raises the hurdle than they must get over just to break even on these attempts.

With an actively managed mutual fund, for example, the mutual fund manager or managers can simply decide to change the composition of the investment portfolio and incur the trading cost and market impact. Every mutual fund manager hopes to gain more than the incremental trading costs, when they do this.

Of course, when all these collective buy and sell decisions are made, fund managers are more likely to be wrong than right. They have no crystal balls about what will happen to securities market values in the future. For every securities buyer there must be a seller and for every securities seller there must be a buyer. Actively managed mutual fund portfolios get rearranged, trading costs go up, and total net performance must come down.

If you are considering investing in a very large actively managed mutual fund, you should think about the alternative of investing in a noload mutual fund that targets the same index benchmark.

No load index funds do significantly less trading through their buy-and-hold strategies. They have a lower likelihood of a performance shortfall due to their market trading impact. Of course, index fund expenses should be substantially lower, which is also much more likely to improve net investment performance.

As mentioned above, when an actively managed mutual fund’s size grows very large, its portfolio holdings may also move closer to the composition of the market index. There is strong evidence that the portfolios of most very large, large, and even medium sized actively managed mutual funds closely resemble the composition of the passive indexes against which their performance is benchmarked.

However, the annual percentage expense ratios of these actively managed funds are far higher than the annual percentage fees of passively managed index funds. Active mutual fund shareholders are charged much higher annual management expense ratios across both the active and passive portions of their portfolios.

In effect, you pay an extremely high asset management fee for just a little active management. This is because you pay a higher management expense ratio across all fund assets, but only a much smaller portion of the investment portfolio is really being managed actively.

Of course, portfolio managers might disagree. Nevertheless, how do they explain the most likely outcome, which is to relatively closely track, but usually under perform the benchmarket? Whatever the reasons or excuses, you can decide if you want to keep paying high fees for closet indexers who under perform.

More often than not individual investors lose, when they hold actively managed mutual funds. The longer the time period is that investors hold actively managed mutual funds, then the smaller and smaller the chance is that they will actually “beat the market.” Sadly, this transfer of assets from individual investors to mutual fund companies has continued and has grown for decades. It is well past time for individual investors to wise up!

1) http://screen.morningstar.com/FundSelector.html This is Morningstar.com’s free mutual fund screener. Check the Sitemap for our articles about free online fund screening applications and databases.

2) http://screen.morningstar.com/ETFScreener/Selector.html This is Morningstar.com’s free exchange traded fund screener. Check the Sitemap for our articles about free online fund screening applications and databases.

Tags: stocks and bonds, stock and bond, actively managed mutual fund, mutual fund performance, no load index funds

Screen Out Inferior Mutual Fund Performance

Screen Out Inferior Mutual Fund Performance — BUT ONLY AFTER using other ETF and mutual fund selection criteria

Superior or even average mutual fund performance in the past simply DOES NOT predict similar fund performance in the future.

However, the investment research literature does provide some modest evidence that substantially inferior past mutual fund performance is more likely to lead to inferior mutual fund returns in the future. Excessive costs and high management expense ratios are the likely culprits, when explaining sub-par diversified investment fund returns.

Choosing solely from among mutual funds that have performed very well in the past can lead you to very significant mutual fund screening errors

The primary objective of using scientifically grounded mutual fund screening criteria is to identify a much smaller group of mutual funds for more careful evaluation. Of course, the whole point of screening mutual funds and ETFs is to increase your chances of investing in funds that are more likely to perform better in the future on both a sustained, long-term basis and on an risk-adjusted investment basis.

As a first step in their mutual fund screening process, far too many individual investors and their financial advisors instinctively start by sorting funds on the basis their superior historical performance. They want to choose only from among those mutual funds that have performed the best in the past. They hope that superior past performance will continue into the future.

Both this instinct and this mutual fund screening approach can be fatally flawed. Choosing only from among past higher performing diversified investment funds can lead to major mutual fund selection mistakes. These mistakes arrive in many forms, including inferior gross mutual performance, higher management expense ratios, expensive sales loads and marketing fees, and/or higher trading costs due to higher fund turnover.

How smart, but naive, individual investors may choose lousy mutual funds on the basis of superior past mutual fund performance

For example, if you choose a high cost and high turnover five-star fund with a superior, but largely lucky, past mutual fund performance record, then you can set yourself up for some real future investment performance troubles. If this mutual fund performance record does not continue into the future, then you will still end up paying a high management expense ratio and high, hidden fund turnover trading costs.

You will just to get mediocre future performance on a “gross” returns basis. When higher annual management expense ratio costs, higher hidden trading or turnover costs, and higher short term capital gains taxes are taken into consideration, then the result will be inferior performance on a “net” returns basis. What appeared to be a big winner, when it was owned by someone else, becomes a big loser, when you own this fund.

An additional reason why you might have decided to buy this high cost mutual fund could have been, because you were only sold “superior” mutual funds. Perhaps a financial advisor selectively offered to you only those mutual funds with higher past performance and 4-star and 5-star mutual fund ratings. Because you were naively inclined to buy on the basis of past performance, it was much easier for the investment counselor or financial adviser to make the sale to you by suggesting only four star and five star funds.

In the process of purchasing this fund, you may also have paid a substantial front end sales load or back end sales load. If you paid a sales load, then an annual 12b1 marketing fee probably was also tacked on to the annual management expense ratio to pay your financial advisor to “serve” you.

Now, your investment picture gets even worse. Instead of putting 100% of your dollar to work in the investment fund, perhaps only 95 cents will actually make it into the fund to work for you. In addition, the 12b1 fee drives up your annual costs even higher.

You bought this fund, because you earnestly thought you were buying a “better” mutual fund or ETF. It seemed like a good investment, because the past mutual fund performance had been better. Furthermore, your financial advisor or investment counselor, actually said that the fund was “better” fund or at least implied that this was a better fund by pointing out its performance chart or its then 5 star rating, which has since faded and lost its sparkle.

Securities sales brokers, investment counselors, and financial advisors get paid more, when you pay them more. That is why they shamelessly tell you or imply that you must buy more expensive diversified investment funds and “pay more to get better performance.” This is unmitigated rubbish.

Investment research studies indicate that superior past mutual fund performance simply does not indicate that there will be superior future performance — particularly after higher costs and taxes are considered.

When historical mutual fund performance is evaluated carefully in well-designed statistical studies, there is very little evidence that managers of funds with superior past performance will sustain this performance into the future. (ETFs are too new to have a similar body of historical research, but the substantial similarities between mutual funds and ETFs make contrary findings unlikely.)

Past fund success is simply not an indicator of future success.¹ In fact, superior past fund performance seems not to indicate any more than the likelihood that a fund is likely to have average performance in the future. Funds that recently demonstrated average performance in the past are equally likely to have average or superior performance into the future, as well.

Therefore, previous superior or average past mutual fund performance does not predict similar future performance. Some average and some superior performing funds in the past will be average in the future and some will do better or worse than the average.

An average or superior past performance chart tells you absolutely nothing to aid you in your mutual fund selection process. However, there is modest evidence that substantially inferior past fund performance is more likely to lead to continued inferior performance in the future. Significant past failure is a mild indicator of future failure.

Given that big past losers have a mild tendency to keep losing, but past winners are likely to be average in the future, these findings should change significantly how one should use historical performance indicators. Instead of starting by selecting only the best past performers, The Pasadena Financial Planner believes that investors are far better served by first applying other much more useful mutual fund selection criteria.

Before evaluating past mutual fund performance, use the first 6 of these 7 objective mutual fund and ETF screening criteria.

These 7 screening criteria can help you to screen the tens of thousands of available diversified investment funds to get down to a more manageable list of diversified investment funds to evaluate. The first 6 mutual fund screening criteria below will yield a much shorter diversified investment fund list.

Only then, should an investor use historical performance measures to evaluate the screened list and only then with the sole objective of eliminating those funds that have had a history of sustained and significant under performance. The investor can then use the web and other sources to research in greater depth the remaining funds on the screened list – whether or not their prior performance has been average or superior. Just eliminate any funds with substantially inferior past performance from this smaller diversified investment fund list.

Note that in reality however, after you have knocked out funds with 1) sales loads and 12b1 fees, 2) high management expense ratios, 3) high turnover and trading costs, 4) large actively managed funds, 5) immature funds, and 6) small inefficient funds, you are relatively unlikely to have any funds remaining that have substantially inferior past performance. Since these other six mutual fund screening criteria are inversely correlated with lousy mutual fund performance, you are very likely to have already eliminated the past performance dogs. as well.

1) The Best Mutual Funds Have NO Sales Loads and NO 12b-1 Fees

The great majority of investors buy funds through financial advisors, and they pay a very, very high price over their lives for doing so. This is especially true, since financial advisers tend to promote funds with higher costs that reduce mutual fund performance. Zero is the maximum amount of front-end load and back-end load fees that you should to pay. Zero is the maximum marketing or 12b-1 fee you should pay. Just say no. Buy no load mutual funds directly without using costly advisers.

2) The Best No Load Mutual Funds Have VERY LOW Management Expenses

Lower annual ETF and mutual fund management expense ratios are better. Lowest is usually best. Many no load index funds and ETFs have management expense ratios below .25%. Favor them.

3) The Best Noload Mutual Funds Have VERY LOW Portfolio Turnover

Lower portfolio turnover is better. Look for single-digit and very low double-digit annual portfolio turnover rates in the no load index funds and ETFs that you purchase.

4) Avoid Large Actively Managed Mutual Funds

When they trade their overly large portfolio positions, large actively managed funds tend to affect securities market prices negatively. This drags down their net mutual fund performance. High turnover by large funds should be a big red flag to you.

5) Choose Mature Mutual Funds

The ETF and mutual fund industry throws a whole lot of new fund spaghetti on the wall to see what will stick. You do not want to be part of this process. Pick more mature mutual funds that have been in business for at least a few years.

6) Avoid Very Small Mutual Funds

Small funds cannot operate efficiently. They need a minimum critical mass of assets to fund required management expenses. Simply avoid very small funds under one hundred million or two hundred million dollars in assets.

7) Screen Out Inferior Mutual Fund Performance

Evaluate the historical investment performance of mutual funds and ETFs, but only AFTER using other screening criteria. Superior or average past fund performance tells you ABSOLUTELY NOTHING about how a fund will perform in the future. Pay attention to the fine print in the prospectus that says that past performance does not indicate future performance, because this has been shown to be true.

Modern, highly competitive, and real-time securities markets are auction price setting mechanisms that force the mass of smart and not-so-smart professional and amateur investors to accept largely average returns over time. Only very poor past performance tends to indicate potentially sub-par performance in the future, and that is probably due to higher costs. Therefore, eliminate only the worst of historical performance during fund screening and choose from the remainder — despite whether a fund has had superior, average, or even somewhat below average performance in the past.

Net of costs, four and five star funds are no better than three star funds and probably no better than even two star funds. Eliminate the bottom one-tenth to one-third of funds on a historical performance basis and choose from the remaining nine-tenths to two-thirds without stressing their past performance. Instead, choose no load index funds with very low costs and turnover. (Also, see: Do Morningstar Ratings predict risk-adjusted equity mutual fund performance?)

1) Mark M. Carhart “On Persistence in Mutual Fund Performance.” The Journal of Finance, 1997, Vol. LII, No. 1: pp 57-82

Tags: mutual fund screening, mutual fund selection, diversified investment fund, mutual fund performance
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