8 Rules for Selecting Actively Managed Mutual Funds

I’m currently reading John C. Bogle’s book, “Common Sense on Mutual Funds”. In his chapter on simplicity he stresses a buy and hold investment strategy to best keep pace with average market returns. To attain as close to average market returns as possible, Bogle recommends simply owning the entire U.S. stock market via index fund, holding asset allocation constant and minimizing transactions. Bogle makes a very compelling argument for investing your retirement funds in index funds over actively managed mutual funds. He claims only one of every seven actively managed mutual funds outperforms the market index after taxes. Bogle outlines 8 simple rules if you do decide to go with the actively managed mutual fund investment route.

Rule 1: Select Low-Cost Funds

Bogle argues that the expense ratio is the most important factor in the performance of a fund’s overall performance. It’s pretty simple really, high cost funds have to achieve a return equal to the difference in expense ratios just to obtain the return of a low cost fund, with all else being equal. With the unpredictability of a mutual fund’s performance, starting at a disadvantage equal to the difference in expense ratios is just plain unintelligent.

Rule 2: Consider Added Costs of Advice

This rule is extremely similar to the first rule. Many mutual funds have loads associated with the purchase or sales of shares. There is absolutely no reason to purchase a load fund for the same reasons mentioned in rule one. If you absolutely have to purchase a load fund, at least maintain the fund for a reasonable period of time, as the longer you hold the fund, the more you minimize the effect of the load fee.

Rule 3: Beware Past Fund Performance

For various reasons, statistics show that past performance of mutual funds does not provide an indication of future returns. Bogle states that two forecasts can be made about future returns. First, he states that funds with really high expenses are likely to underperform the corresponding index. Second, he states that funds with substantially superior returns will regress towads the market mean.

Rule 4: Use Past Performance to Evaluate Consistency and Risk

Bogle does recommend using past performance to evaluate the past consistency and risk of mutual funds. The past consistency and risk of a mutual fund is indicative of future consistency and risk. Bogle recommends selecting mutual funds with consistent results and risk along the lines of what has been determined acceptable for each individual. Morningstar provides the necessary data to study the past consistency and risk of mutual funds.

Rule 5: Beware of Star Funds and Manager

Bogle recommends staying away from “star” mutual fund managers. The average portfolio manager remains with the fund for five years. Considering retirement savings takes place over a much longer time period than five years, following a mutual fund manager can become quite costly due to fees from switching funds and does not gaurantee sucess. Additionally, the mutual fund managers that have had staying power and great success such as Peter Lynch, were unknown until after providing that great success.

Rule 6: Beware Asset Size

The asset size can severely limit returns for mutual funds. There is no magic asset size that is too large, as a fund investing in large cap stocks can handle more in assets than a fund investing in small cap stocks. The reason for the diminished returns with increasing asset size is that it becomes harder and harder to manage the assets. Either the manager has to find more stocks that will provide above average returns or the manager has to invest more assets into the same stocks. Making large stock purchases or sales results in an increase and decrease in stock price, respectively. The change in stock prices diminishes returns. Bogle recommends avoiding funds that have no history of closing funds to new investors or appear willing to let funds grow regardless of size.

Rule 7: Limit Number of Funds

Bogle provides a statistical analysis from Morningstar Investor that analyzes the effect of the number of funds on risk. Adding more than four funds does not reduce the risk by a significant amount. Adding more than four funds does not diminish returns, but Bogle recommends a four or five fund investment strategy to maintain simplicity, while minimizing risk.

Rule 8: Buy and Hold Funds

Bogle recommends a buy and hold strategy to maintain simplicity and reduce costs. He argues that if you select your mutual funds correctly to begin with, rebalancing once a year is all that is necessary to maintain your retirement portfolio. Barring a major event such as the introduction of new fees, merger of its management company or change in investment policy, Bogle recommends a buy and hold strategy.

Overall, Bogle recommends investing in a total market index fund. His 8 rules for selecting actively managed mutual funds tend to make your retirement portfolio as close to an index fund as possible. I personally believe index funds are the way to go when investing for retirement, but if you’re the type of person who believes that the intelligence of a mutual fund manager can outperform the market, these 8 rules will help you select a decent portfolio of actively managed mutual funds.