How to pick a great mutual fund

By Scott Burns

With the number of mutual funds approaching the population of Cleveland, you and I face a dilemma: How do we choose?

What's the best method for selecting a fund that has a good chance of earning a higher return than at least 50% of its peers?

Is there a simple way to do it? You know, some way that real people -- the kind who sometimes forget to floss -- might do it?

Well, fellow forgetful flossers, there is a way. As you'll soon see, we can increase the odds of superior performance to more than 70% with one simple measure: the annual expense ratio, the percentage of assets that go toward management fees and operating costs.

We can do this with one of my favorite tools, Morningstar Principia. If you aren't familiar with it, it's a software/database product that helps you explore the universe of mutual funds.

Avoiding the grab bag

Let's start with this problem. Today there are 530 mutual funds with 10-year track records that invest in the broad category of large blend. This means they invest in a broad mix of the largest domestic companies. The number of funds is so large because most fund companies distribute their funds through different mechanisms, and each variation appears in the database.

If we reach into this grab bag and pull out a fund at random, there is a 50% chance it will be better than, or worse than, the median return for the group. Over the past 10 years, the median return has been an annualized rate of 6.73%. The average return was slightly higher, 6.96%.

Our task is to find a simple way to improve the odds.

If we sort them by expense ratio, we learn that the more expensive half had an expense ratio of at least 1.10%, an average 10-year annualized return of 6.74% and a median return of 6.42%.

The less expensive half had an expense ratio of 1.09% or less, an average annualized return of 7.17% and a median return of 6.84%. So they tended to be better than average. They beat the more expensive funds by an average of 0.43 percentage point.

The difference changes the odds of selecting a better-than-average fund. Among the 265 expensive funds, only 113 beat the median return for the entire group. If you picked a fund at random, you had only a 43% chance of selecting a fund with superior performance.

If you picked a fund at random from the 265 less expensive funds, 151 would have provided superior returns. You'd have a 57% chance of selecting a superior performance fund.

Selecting from less expensive funds provides a simple but significant edge. That edge, unfortunately, is largely unavailable to the typical fund salesperson/adviser.

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Why? Because 150 of the funds in the high-expense group have front-end or deferred sales loads, while only 35 of the funds in the low-expense group have front-end or deferred sales loads.

Of course, it's still possible for a salesperson/adviser to pick a winning fund. There are high-expense funds with superior performance. And there are some low-expense load funds. But the odds are against the salesperson/adviser. Most of his or her selections come from the disadvantaged high-cost pool.

Refining the formula

Query: Can we push this method further? If shopping in the less expensive half of funds gives us an advantage, what happens if we compare the most expensive one-eighth of funds with the least expensive one-eighth of funds?

The odds get still better.

To be in the most expensive one-eighth of large-blend funds, it was necessary to have an expense ratio of 1.86% or greater. This group provided an average return of 6.21%. Only 21 of the 67 funds in the group did better than the median for the original group of 530. So your chance of achieving superior performance through high expenses is only 31%.

The least expensive one-eighth of large-blend funds had an expense ratio of 0.50% or less and provided an average return of 6.90%. More important, 49 of the 69 funds in the group provided superior returns, so you had a 71% chance of superior performance simply by selecting the least expensive funds.

Questions about personal finance and investments may be e-mailed to scott@scottburns.com. Questions of general interest may be answered in future columns. More columns by Scott Burns can be found here.