Let’s look at several of the criteria to consider when choosing mutual funds in which to invest.

Past performance: After deciding which mutual funds have investment objectives that are compatible with their own, most people probably start checking the past performance of these funds to determine which ones have had the highest returns. However, there is ample evidence that past performance is not usually much help in determining who the best money managers are likely to be in the future.

An article in The Wall Street Journal (10-27-92) made the following statements regarding the performance of professional money managers:

A winning track record is the first – and sometimes the only – thing that most investors look for when entrusting their money to a professional manager.

But while a great track record may seem very alluring, it’s just as likely to be dangerously misleading.

[I]mpressive performance numbers tell nothing about how the portfolio stacks up today. . . . [I]t’s today’s investment choices – not yesterday’s – that determine how a manager will do in the future.

Two managers who did equally well in the past may be making diametrically opposed bets today.

The shorter the track record under consideration, the harder it is to know for sure who’s competent and who’s not.

For that reason, most pros give little weight to recent performance numbers in trying to identify superior managers. They focus instead on . . . a manager’s investment process over the very long term.

One of the biggest traps investors fall into is to put money into the absolute top performer. . . .

Like roulette players, big winners become top performers by having a very undiversified portfolio, with a big bet in one area that happens to work out. . . . As soon as they hit the jackpot, however, the odds are very low that that will repeat itself in the future.

The article goes on to tell about a study that tested whether investors could predict future performance from the track records of more than 100 managers. The study found that the best-performing managers’ chances of repeating their success were 50/50; i.e., the same as could be determined by merely flipping a coin. In other words, a manager’s past performance gave no indication as to whether or not he would continue to achieve superior performance in the future. However, the article stated that there is less doubt that “investors should shun managers with consistently bad long-term records.”

Likewise, an article in Forbes magazine (8-21-00) indicated that past performance is not helpful in determining who the best money managers are likely to be in the future. The article noted that of the 15 stock mutual funds on its current “honor roll” of consistently good performers over a period of several stock market cycles, only two of the funds had also been on its “honor roll” in the prior year and only one had been on its “honor roll” for more than two years.

Furthermore, ratings by mutual fund rating services don’t seem to be helpful in choosing which mutual funds will outperform.  A newsletter published by the Vanguard family of mutual funds (summer 2010) says,

A common misconception among investors is that owning only highly rated funds (or avoiding poorly rated funds) will surely provide higher returns.

However, [we] found the opposite when we analyzed Morningstar’s mutual fund ratings and compared them against the rated funds’ subsequent performance. [A recent Vanguard research paper] showed that, on average, just 39% of five-star funds outperformed their benchmark indexes in the three years following the initial rating, while 46% of one-star funds outperformed their benchmarks during the same period. In addition, the highest-rated funds were found to post the lowest average returns versus their respective benchmarks.

If you want to avoid the difficulties of attempting to select stock mutual funds that are likely to do better than average, one or more stock index funds may be a satisfactory alternative. A stock index fund should have essentially the same performance as a specific group of stocks that comprise an index, because the manager of the fund usually invests in the same stocks as are in the index. One study cited in The Wall Street Journal (2-27-01) concluded that during the 36-year period through 1997 year-end, most investors “would have fared better in a market-tracking index fund” than in an actively-managed stock mutual fund.

A subsequent study reported in The Wall Street Journal (12-4-05) supports this conclusion. According to this study,

[One certified planner] notes “the more funds you pick and the longer the time period, the worse the odds get.” Indeed, with a single actively managed fund, the chances of beating an index fund [are] 31% over five years, 25% over 10 years and 13% over 25 years.

Suppose, instead, that the two sets of competing portfolios consist of five funds. [T]he odds of an actively managed-fund portfolio beating an indexed portfolio shrink to . . . 18% over five years, 12% over 10 years and just 5% over 25 years.

[T]he odds of beating an indexing strategy would look even worse if you figured in taxes and investors’ bad timing.

Warren Buffett was quoted as saying in a press conference, “For a know-nothing investor, a low-cost index fund will beat professionally managed money. . . . The gross performance may be the same, but the fees will eat into that compared to a good index fund, which is almost cost-free.”

A newsletter published by the Vanguard family of mutual funds (summer 2007) noted that the manager of the endowment fund for Yale University has stated that he thinks people should invest in index funds, rather than attempting to invest on their own or in actively managed mutual funds. The newsletter goes on to say, “It’s a very strong statement from somebody who, in his professional life, does almost only active portfolio management.”

Transaction costs and capital gains taxes: Since changes are made to the stock holdings in an index fund only when there is a change in the stocks included in the index whose performance the fund is attempting to match, the fund’s transaction costs and capital gains taxes can be minimized. In contrast, actively-managed stock mutual funds tend to do much more trading, resulting in much higher transaction costs and capital gains taxes. This hinders the aftertax performance of actively-managed stock mutual funds versus stock index funds.

A Wall Street Journal article (8-31-99) stated,

[Investors with taxable accounts that were invested] in diversified U.S. stock funds surrendered an average 15% of their annual gain to taxes over [one five-year period]. This figure reflects the taxes paid on fund distributions. . . .

By contrast, you would have lost just 4% to taxes if you had owned the Vanguard 500 Index Fund, which doesn’t actively trade stocks, but instead simply mimics the performance of the Standard & Poor’s 500-stock index.

The rapid trading of stock-fund managers, and resulting tax inefficiency, makes it almost impossible for taxable shareholders to beat the market. [W]ith the 100% turnover rate that is typical for a U.S. stock fund, a manager has to beat the market by between 2 ½ and 3 ½ percentage points every year to match the post-tax returns of a comparable index fund.

Another tax consideration is that if you decide to invest in any type of stock mutual fund, try to avoid purchasing shares just before the fund pays a dividend. Otherwise, you may have to pay income taxes on gains that do not benefit you, because the gains were accumulated before you purchased the stock, and they were included in the price you paid for the mutual fund shares.

Annual management fees: A mutual fund’s so-called “expense ratio” is calculated by dividing the fund’s total operating costs by the average net worth of the fund. According to one source quoted in The Wall Street Journal (7-31-05),

Expense ratios are the best predictors of performance – way better than historical returns. . . . You’d be better off randomly picking a fund with expenses in the cheapest quartile and past returns in the worst quartile than a fund with returns in top quartile and expenses in the highest quartile.

The article goes on to state that, according to one study, “the expense ratio isn’t only the best predictor of performance, it is the only statistically reliable predictor.”

The annual management fees charged by stock index funds are usually substantially less than those charged by actively-managed mutual funds. Over a period of several years, this can make a significant difference in the average annual return that is earned. Several studies, including the one we just cited, have concluded that, although low annual expenses (which are reflected in annual management fees) don’t guarantee superior results, they make such results more likely.

If you decide to invest in stock index funds, you can choose from a number of types of indexes, such as the following:

. An index, such as the Standard & Poor’s 500, which tracks large-company stocks

· An index that tracks small-companies

· An index, such as the Wilshire 5000, which tracks almost all regularly traded U.S. stocks

· An index that tracks international company stocks

Sales commission: Regardless of the type of mutual fund in which you choose to invest, avoid paying a sales commission (or “load”). If you purchase mutual fund shares through a securities broker, you probably will have to pay a sales commission, but many other mutual funds are sold directly by the company that manages them and do not charge a sales commission. Since a number of studies have concluded that no-load funds perform just as well, on average, as funds that charge a load, investors generally would be wise to favor no-load funds. However, be aware that some so-called no-load mutual funds may charge a fee equal to several percent of the assets that investors withdraw from the fund, if the shares are redeemed within a few years of the date they are purchased.

You may also want to consider exchange traded funds (ETFs). According to a Wall Street Journal article (9-7-08),

EFTs have provided opportunities to lower expenses, diversify portfolios more, and provide better returns with less risk.

ETFs are index funds that, like stocks, trade throughout the day, instead of being priced once daily like mutual funds. They’re flexible, low-cost, tax-efficient investing vehicles . . . .

While ETFs have the noted advantages, the article goes on to mention that they also have several potential negatives.

[B]e mindful of taxes and trading costs. It may not make sense to overhaul a taxable portfolio with ETFs if you’ve built up long-term capital gains in traditional funds.

And consider how often you’re adding new money. ETFs come with transaction fees, just like stocks. So if you’re dollar-cost averaging . . . in small amounts, ETFs might not be the best course.

A more recent Wall Street Journal article (10-10-10) is much more negative about ETFs, as indicated by the following comments:

[S]tudies suggest that many ETFs are having trouble keeping up with their main promise to investors: to stay as close as possible to, or “track,” the index they’re supposed to follow. . . . Critics say that in a few worst-case scenarios, ETFs’ performance has been exactly the opposite of what their marketing would suggest.

Some of the widely touted tax benefits of the funds can disappear, with some fund problems even creating higher tax bills.