The Best Mutual Funds

“What is the best mutual fund?”

To financial advisors and experienced investors, it’s a silly question. But it’s one that I’ve been asked–very much in earnest–by young people on several occasions. (Actually, it’s usually more along the lines of “So, like…what’s the best mutual fund?”)

For the sake of any investors asking Google that very question, I thought it might be beneficial to take a few moments to provide an answer here. (My apologies to any readers looking for more sophisticated fare.)

It Depends on Your Goals

The most important thing to know when choosing investments–mutual funds or otherwise–is that what’s best for you isn’t necessarily what’s best for me. We have different goals, and we need different investments to meet them.

If you’re saving to buy a house in 3 years, the best mutual fund is one that’s unlikely to decline in value in any given year–even if that fund only provides a modest rate of growth. If, on the other hand, you’re saving for retirement 40 years from now, it’s OK to use a fund that declines in value from time to time as long as you have reason to believe it will earn a satisfactory long-term return.

Generally, the biggest factor in determining a fund’s long-term return as well as its year-to-year volatility is the fund’s asset allocation.

What’s Asset Allocation?

Asset allocation refers to how much of a fund’s portfolio is invested in each asset class (cash, bonds, U.S. stocks, international stocks, etc.). When saving for most goals, you’ll want a mix of asset classes. And rather than looking for “the best fund,” you’ll usually want to create a portfolio of a few different funds.

For the most part, the more volatile an asset class is, the higher its long-term returns have tended to be. As a result, if you’re saving for a short-term goal, you’ll want a portfolio made up primarily of funds that invest in low-volatility, low-expected return asset classes (cash, bonds). And if you’re saving for a long-term goal, you can afford to put more money into funds that invest in higher-volatility, higher-expected return asset classes (stocks).

Look for Low Costs

Studies have found that within a given category of funds (U.S. stock funds, for instance), costs are the best predictor of performance. The lower a fund’s expenses, the better it’s likely to perform. (Not exactly surprising, is it?) When examining a fund’s costs, there are two things to look for:

• A low expense ratio, and
• Low portfolio turnover.

Expense ratio is simply what it costs the fund company to run the fund, and portfolio turnover refers to how frequently the fund buys and sells investments within its portfolio. Because each transaction comes with a cost, higher portfolio turnover means higher costs–costs that aren’t included in the fund’s published expense ratio.

A fund’s expense ratio and portfolio turnover can be found by either reading the fund’s prospectus or by simply doing a Google search for the fund’s name.

Almost without exception, the funds with the lowest costs and lowest portfolio turnover are index funds–mutual funds that simply seek to match the market’s return rather than attempting (and failing) to beat it.

“The Best Mutual Fund (Portfolio)”

In short, for most investors, the answer to “What is the best mutual fund?” is really “A portfolio of low-cost index funds with an appropriate asset allocation for your goals.”

Thrilling, isn’t it?