As of the end of last year, there was more than $9 trillion invested in mutual funds and ETFs. Many investors often look at a fund's past returns to determine future performance, but there are other factors they should consider when strategizing their investments.
Active management vs. passive management. In a recent study by InvestingNerd, only 24 percent of active managers beat the market index over the past 10 years. This isn't necessarily because active managers aren't generating positive returns as well as the index funds, but research shows the fees active managers charge eat away at investors' returns more than the average index fee. Though on average active managers earned 0.12 percent higher annual returns than index investors (they charge a management fee of 1.07 percent), investors are left with 0.80 percent lower returns than index investors. This means the majority of mutual fund investors who used active managers in the past 10 years would have been better off investing in a passive index fund instead. It's important that investors consider a fund's expense ratio when assessing possible future returns from their investment.
Risk vs. return. Many investors like to examine past returns when assessing a fund's performance, but neglect to consider the fund's annual volatility of returns. Say you invest all your money in a highly volatile fund. It has the potential for great return if the investment goes well, or it can cost you everything if the risk doesn't pay off. Risk-averse investors may want to value volatility more heavily and should know that, on average, active managers have done better at controlling risk than index managers. Across all asset classes over the past decade, active funds beat the index funds' volatility of returns by 1.96 percent--meaning active managers are able to earn similar returns to an index fund, but with less risk. To these risk-averse investors, paying more in management fees may be worth the slight decrease in returns for the added risk protection on their investments.
Small vs. large funds. InvestingNerd's study found that larger funds typically outperform smaller funds. As fund size increases, expense ratios decrease because there are more investors who can cover the base costs for the fund's management. One explanation for the larger fund's outperformance of smaller funds: The higher expense ratio on those funds eats away at investors' returns.
The lesson for investors. While it's important to look at past returns when choosing mutual funds, investors should also look at the fund's expense ratio to get a better sense of its after-fee returns. In addition, investors concerned with risk should review the fund's volatility of returns and risk-adjusted return rate. A fund's size can also impact the fund's performance, as higher assets under management could be the cause of a fund's superior performance. To screen mutual funds based on these variables, investors can use NerdWallet's Mutual Fund Tool, which screens more than 15,000 mutual funds using these key performance metrics to help investors find the best fund for their investments.
Neda Jafarzadeh is a financial analyst with InvestingNerd. InvestingNerd helps investors compare mutual funds to find the best strategy for their investments.