Superior Performance

Studies have shown that there are various factors that contribute to superior mutual fund performance over time. First and foremost among these is the portfolio manager. A talented portfolio manager with a track record of solid long-term performance is key. [Long-term performance with respect to mutual funds should be defined as at least 3-5 years.] When analyzing the historical performance of a mutual fund, an investor should verify that the fund’s performance is due to the current portfolio manager. If the fund has outperformed its benchmark over the last 10 years but the current manager has only been at the helm for one year, then historical performance may not be relevant. Investors should pay more attention to a fund's performance during the term of the current fund manager.

Minimizing fees and expenses is extremely important to above average, long-term performance. Again, many studies have shown that this is often one of the most important factors in achieving superior performance over the long-term. At Reyes Capital we choose no-load funds exclusively. We define "No-Load" as a fund with no upfront sales charges or commissions. Most loads or commissions paid by an investor to buy a mutual fund are simply used as sales incentives to compensate the broker who is selling that mutual fund. A 3%, 4% or 5% commission is simply another hurdle that a mutual fund will have to overcome in order to outperform its benchmark. With over 8,000 mutual funds to choose from today, there is seldom any good reason to choose a load fund.

Investors should be wary of other fees and expenses when purchasing a mutual fund. Every fund has an annual operating expense ratio. This is simply the cost of running the mutual fund, and goes to paying the portfolio manager and analysts, trading costs, running the offices, etc. This fee averages approximately 1.5% for actively managed US Large Cap funds. The key here is to choose a mutual fund that is below the average, and hopefully well below the average. Another fee is known as 12b-1. It is a marketing fee used by the mutual fund company to market its mutual funds. This fee can be as high as 1%. Investors should stick to mutual funds with no, or very low, 12b-1 fees. (Low can be defined as 0.25%.) The last fee to watch out for is called a Contingent Deferred Sales Charge, or CDSC's. This is a charge levied on investors if they attempt to sell a mutual fund. This fee is graduated, and is typically 5% of assets if the fund is sold in the 1st year, 4% if sold in the 2nd year, 3% in the 3rd year, etc. In addition to being extremely onerous, they act as a deterrent to selling, and may trap an investor in a poorly performing fund. CDSC's are often masked in a confusing web of different share classes, such as A-shares, B-shares, etc. - these should be avoided as well. A no-load fund with a low expense ratio, no 12b-1 fees, and no CDSC's is what every investor should look for.

Other factors that contribute to, or detract from performance are: 1) turnover and 2) relative level of assets in the fund.

  1. Turnover Turnover is defined as the amount of trading a mutual fund manager does over the course of a year. Investors should look for mutual funds with low turnover, generally defined as less than 100%. High turnover leads to high trading costs and short-term capital gains which are tax inefficient.
  2. Relative Level of Assets Paradoxically, the smaller the size of the actively managed mutual fund, the better. This is because a smaller fund is more nimble and can take advantage of opportunities more quickly. Large funds must hold many stocks, and large quantities of each. Because they hold many stocks, it is very difficult for them to outperform their respective benchmarks; and if something goes wrong, they cannot sell out of a position all at once. If they did it would adversely affect the stock's price. Therefore, mutual fund portfolio managers are forced to hold most of a disastrous stock until it can be sold piecemeal over time. Due to these factors, a mid-cap fund should have less than $5 billion under management, and small cap and international funds should have less than $2 billion under management.

Some mutual funds perform extremely well some years, only to be followed by exceedingly poor performance the following year. Novice investors will be lured into purchasing these hot mutual funds and often get caught "chasing performance". Statistically it has been shown that the funds that make the very top of the performance charts one year are often near the bottom of the rankings the next year. This is because that chart-topping performance is usually achieved by investing in very risky securities, or through risky strategies involving leverage and/or concentrated positions.

Investors should look for mutual funds that have a consistent record of above average performance over many years, without taking outsized risks.