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Three Tell-Tale Signs Your Mutual Fund Stinks


But even if it does, there's still a silver lining.

So you bought a few mutual funds for retirement, to fund a child's education, and to build some wealth.

Or maybe you see the S&P 500 more than a third off its highs and you want to take a chance on a rebound by putting some money to work in a new mutual fund.

Big mutual fund companies like T. Rowe Price (TROW) and Franklin Resources (BEN) have huge research departments and trading operations, not to mention large teams of money managers with impeccable educational backgrounds and credentials. But even that can't change the reality that most mutual funds stinks.

So how do you know if your fund stinks? Here are 3 tell-tale signs:

1. It's an actively managed fund

If there is one unassailable truth to mutual funds, it is that boring index funds - which aim to match the market's performance - outperform actively-managed ones. There are exceptions, like Peter Lynch's incredible run with Fidelity (FBS) Magellan from 1978 to 1990. But with thousands of funds to choose from across dozens and dozens of categories, what are the possible chances that you'll identify the next hot fund before it begins a huge winning streak?

Legg Mason's (LM) Bill Miller became a star for beating the S&P 500 15 years in a row with Legg Mason Value Trust (LMVTX). Unfortunately, that run was followed by a three-year slump so painful that it offset his big winning streak.

2. It's expensive

Investors have minimal control over the future returns over their mutual funds. The phrase "past performance is no guarantee of future results" is actually true! But what you can control is expenses. FINRA, the leading securities firm regulator, has a handy-dandy mutual fund analysis tool which allows you to estimate the impact of expenses on performance.

I find the FINRA calculator to be very effective because it outputs easy-to-understand charts and keeps track of all fees and charges. It's enough information to make an informed choice but not enough to bog you down.

If you're looking at two similar funds, always choose the less-expensive option, "regardless of past performance."And please avoid mutual funds with up-front sales charges -- there are plenty of funds without them.

Another point for index investors: actively managed funds have much higher expense ratios than index funds - sometimes by a full percentage point or more. Depending upon the size of your portfolio, hundreds or even thousands of dollars a year could be going straight from your pockets into the toilet.

Why pay more for inferior performance? If you want to throw away money, take an expensive vacation and party! I recommend the Greek Isles.

3. It overlaps your other investments

A mutual fund provides instant diversification because it can own 50 or 100 or even more stocks. That makes it easy to get broad stock-market exposure without the headaches of owning individual stocks.

But most mutual funds in any single category (large cap growth, technology sector) are going to own a lot of the same stocks, and thus will perform similarly. So if you own a small-cap growth fund, don't buy another, no matter how attractive it seems. You won't see a real difference in performance -- but you will get more junk mail and paperwork to deal with at tax time. If you own more than one fund in any category, you own too many.

The Good News For Owners of Stinky Funds

If your funds suck, it's not the end of the world. In fact, it may be the perfect time to dump your losers and swap into cheap, boring, and superior index funds. With the market so far off its highs, you may qualify for a tax deduction if you've lost money.

But before making any moves, it is imperative that you speak with a tax adviser. By selling at a loss and swapping into similar funds, you could get caught in the IRS' wash sale rule, which prevents tax deductions on losing investments if similar ones are bought within a certain time frame.
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