3 key factors to pay attention to when selecting mutual funds

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Mutual fund fees have long been a hot topic in the investing world and now there’s a daily barrage of commercials claiming that switching to passive-style exchange-traded funds will result in us retiring 30 per cent richer.

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The passive-versus-active management debate will rage on, but mutual funds have their place in the investment industry for good reason. Actively managed mutual funds can provide significant advantages to investors, such as diversification, unique portfolio construction, professional management and liquidity, all in a cost-effective package.

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Unfortunately, the “you get what you pay for” adage doesn’t apply to the world of mutual funds. Actively managed mutual funds can be a valuable investment tool, but not all funds are created equal. There are more than 5,000 mutual funds in Canada and the funds that deliver on those promised benefits are a minority.

To ensure you’re getting the most value for your money, it’s critical to do your due diligence and look beyond a fund’s performance record. Here are three key factors to look for.

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Over-diversification

Diversification is a crucial factor when selecting a mutual fund, but it’s important to remember that doesn’t mean owning as many different investments as possible. Over-diversification is a pitfall to be wary of. Owning too many investments can reduce a portfolio’s potential returns, increase trading costs and make it difficult to keep track of your investments.

Instead of owning hundreds of different investments, aim for a well-diversified mutual fund with a portfolio of around 20 to 40 investments. Make sure the investments are spread across different sectors and regions, and that they aren’t all highly correlated with each other. This can help to reduce your portfolio’s risk and increase the chances of achieving your investment goals.

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Management: Beware of closet indexing

Closet indexing is when a fund manager closely tracks a benchmark index while charging higher fees than a passive index fund. This can be detrimental to your portfolio’s performance and your overall investment returns.

You are also paying for a service that you’re not receiving. The manager has no intention of beating the benchmark index, or actively managing the portfolio. Instead, they mimic the index as closely as possible and collect their fees as if they are adding value.

Unfortunately, this practice is more prevalent than the industry would like to admit. To spot a closet indexer, look for a high correlation between the fund’s returns and the benchmark index it’s supposed to be outperforming.

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You can also check the fund’s active share, which measures the percentage of holdings that differ from the benchmark index. If the active share is low, it could be a sign that the fund is closet indexing.

Fund flows

A mutual fund’s fund flows are a powerful indicator that reveal the ebb and flow of money in and out of a fund. It provides valuable insights into investor confidence and trust in a fund’s management and strategy.

A mutual fund experiencing net outflows could signal that investors are losing faith in the fund’s ability to deliver strong returns. This loss of confidence can be a warning sign for investors to consider reallocating their assets to other funds with better performance prospects. Moreover, a fund faced with significant net outflows over an extended period can become a serious drag on its overall performance.

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Outflows can force fund managers to sell positions to cover the withdrawals, which can be particularly challenging during times of market volatility. If this happens, managers may be forced to crystallize losses or sell winning positions during the most challenging times in the market, which can impact the fund’s long-term performance.

There are many mutual funds with great mandates, exceptional management and a long history of above-average returns. It can take a bit of extra work to find them, but investing your time to do your research or talk with your adviser can be worthwhile when it comes to your financial future.

Taylor Burns is an investment adviser at Manulife Securities Inc. he can be reached at tburns@balfin.ca. The opinions expressed are those of the author and may not necessarily reflect those of Manulife Securities.