How to make sure your fund manager earns his keep

Actively managed mutual funds often don't out-perform tracker funds – yet many charge high management fees. So how can you ensure your fund is worth the money you're paying?

If you want to make big returns on your investments year after year for many years, listen to David Swensen. Swensen is the widely respected chief investment officer of the Yale Endowment Fund. He made Yale more than 16% per year for two decades. That kind of compounding gives you 20 times your money in about 21 years. Imagine retiring with 20 times what you have right now.

Making that kind of money as an investor is a rare achievement. Mutual fund investors know this better than anyone...

On the subject of mutual funds, Swensen says, "A miniscule 4% of funds produce market-beating after-tax results with a scant 0.6% (annual) margin of gain. The 96% of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8% per annum."

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Wow. 96% of all mutual fund managers make less money than a simple index fund... and charge you fees for doing so. The obvious lesson from all this is to be very picky about who's managing your money. You only get one shot at compounding your wealth over decades... so every single percentage point you can earn is worth millions.

Today, I'm going to show you how to avoid garbage funds. And I'm going to tell you how to find the perfect mutual fund. If you know what to look for, you can save yourself a lot of money and headaches over the coming years.

The perfect mutual fund has five key attributes that tell you it's safe enough for your retirement savings and will earn enough money on your investment. Take a look at the funds you own this weekend. If they don't meet the following high standards, consider selling them and switching to the small handful of funds that do.

First of all, management should act in the shareholders' best interest at all times, even if it means closing the fund. One of my favourite funds stayed closed for more than two decades, during which time it could have grown many times its current size.

That would have earned more fees for the fund's management. But it also would have made it much harder for management to produce the kind of returns that multiply your investment by a factor of 200. It's almost impossible to produce outstanding gains when you're trying to put a huge amount of money to work.

Second, management should not be in business to soak investors by charging high fees. Some of the best mutual funds in the world charge just 1% of assets under management. If you're paying over 1.5% in expenses to your fund manager, you're overpaying.

Third, the best mutual funds only buy the very best companies on Earth. There aren't 200 truly exceptional companies in the world worth buying. Probably less than 100. The best mutual funds focus their attention (and your money) on their very best ideas. The ideal mutual fund holds 15-30 stocks. Somewhere in that range is the perfect balance of diversification and focus.

Fourth, the perfect mutual fund holds stocks for the long term. When you buy the best companies and hold large positions, it makes no sense to trade in and out quickly. The average large-cap blend mutual fund holds stocks for an average of about 17 months. Not even two years.

Many mutual funds hold hundreds of stocks, and turn over their entire portfolios every year. They don't know what to buy, and they don't know what to sell, so they're constantly buying and selling.

Finally, you want to invest in a mutual fund whose managers invest their own money right alongside yours. This is a no-brainer. It's also hard to find. But why would you ever give your money to a fund manager whose interests weren't exactly the same as your own? The fund managers at Third Avenue and Longleaf who I admire a lot have significant chunks of their net worth right beside their investors.

Do yourself a favour next week. Print off this list. Call your mutual fund managers and go over it with them. If they don't meet these requirements, they should have a good explanation for why not. If you're not happy with the explanation, dump them.

This article was written by Dan Ferris, a regular contributor to DailyWealth, a free daily investment letter that details unique investments you'll never read about in the Wall Street Journal, Forbes, or any mainstream press. To receive a free report on our latest way to potentially make hundreds of percent returns with very little risk, click here.