If you invest in mutual funds, the single most important act is choosing the fund. There have been many guides and articles written about the process, but they all pretty much boil down to the same thing. They say: 1) choose funds with a good track record, 2) choose funds with low costs, and 3) since the market isn’t consistently beatable, select index funds. Well here is a decidedly contrarian way to select mutual funds that will go (at least in part) against the grain of those three rules.
Choose funds with a rotten track record
That may sound crazy, but in reality the opposite sounds more crazy. If real estate stocks were up three years in a row, does that mean it’s time to buy a real estate mutual fund? No, probably just the opposite. Real estate at that point is probably expensive. Better to invest in an area that has underperformed. Some studies have shown that a fund that was in the top quartile one year will most likely be in the bottom quartile the following year. This rule doesn’t apply in all cases. If a particular fund manager has done well year in and year out, then the track record may be very relevant. But Peter Lynch’s success with the Fidelity Magellan fund in the 1980’s has no bearing on what that fund does today since he left the fund years ago. So look for underperforming areas to invest in.
Pay more fees
I’m not suggesting investing in high fee mutual funds or getting into a loaded fund when no-loads are available. But there is a couple of situations where paying more makes sense. One is with the so called ‘no transaction fee’ mutual funds that brokers such as Charles Schwab are offering. In reality they are getting a payment of between .25% and .35% per year from the fund. Guess who is paying that fee? To buy a regular fund from a broker might cost $35. But if $100,000 is invested in a ‘no transaction fee’ fund, that .25% comes to $250 a year in fees. $35 is a lot cheaper. Those fees sometimes show up as a 12b-1 charge of .25% in the prospectus for the fund, but not always. Regardless, those funds generally have higher total fees, so paying the one time commission makes more sense.
Choose active management
There has been a lot written in the press recently about how passive management beats active management. The idea is not to try to pick stocks, but just to mirror an index like the S&P 500. But like most of those things, it depends on what data you are looking at. If one chooses different time frames and different parameters the opposite can be ‘proved’. According to a recent article in Forbes, ex-fees active management beats passive management most of the time. With small stocks particularly active management wins out virtually all of the time. To me that means that instead of choosing index funds, choosing low fee actively managed funds, for two reasons. First, because over time they’ll probably do better. Second because someone should be watching the money. Just like flying on autopilot all the time doesn’t make sense, I don’t think autopilot investing does either. Maybe if someone came up with a hybrid passive/active fund with really low fees (Fidelity are you listening) that would do the trick.
Is this easy to do? No, especially in choosing poorly performing funds. But in the long run one has a good chance to take less risk, pay less, and make more money taking a contrarian view of mutual funds.