The best long term mutual funds hold well-diversified portfolios of high quality stocks—stocks you can hold for a long time.

The topic of how to pick the best long-term mutual funds came up at the office recently. About a month ago, a friend’s son was considering joining his employer’s group RRSP, and his father asked us to look through the list of mutual funds the son had to choose from.

We went through the list and treated it the same way we do when we consider new mutual funds to follow using the criteria we would use in our Canadian Wealth Advisor newsletter. That is to say, start by using a process of elimination.

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A three-step process for identifying the best long-term mutual funds

First, we eliminated anything with “asset allocation” in the name. If the fund’s name includes the term, it means the fund’s managers or sponsors feel they can enhance returns and/or reduce the risks of their mutual funds by switching back and forth among stocks, bonds and cash equivalents, often using a so-called “black box,” a computer program that makes trading decisions based on a pre-selected set of rules for interpreting financial statistics.

Asset-allocation programs are like hindsight; they work great when they are applied to the past, since their creators can tweak the rules to match what actually happened. They are far less effective at extracting profit in real time. However, they always work great at jacking up a fund’s expenses, because of the commissions their trading generates.

Second, we eliminated anything with “balanced” in the name. Mutual funds that have the term in their names own stocks and bonds.

Balanced mutual funds tend to do less trading than asset-allocation funds, and balancing a fund between stocks and bonds can dampen volatility. However, while bonds are less volatile than stocks, we feel that bonds are unlikely to perform as well in the next few years as they have in the last few, if only because interest rates may hold steady or rise. That means the balanced mutual funds would only earn interest income on their bonds; instead of capital gains, their bond holdings could produce capital losses.

Moreover, bonds now yield less than 5%, and stocks yield 10% or so over long periods. The time remaining before my friend’s young son (he is in his early twenties) retires certainly qualifies as a long period.

Third, we eliminated the theme mutual funds where the theme is plucked from today’s headlines. Theme funds are funds that focus on investments in broad areas such as alternative energy, health, science, resources or whatever. These funds often suffer from pseudo-diversification. That is, they have lots of different stocks in their portfolios, but these stocks all respond to the same economic factors.

Some theme funds can be too narrowly focused on current investment fads to be long-term mutual funds. These types of theme funds appeal to impulsive investors who pour money in just as the fund’s theme hits its peak. This can force the manager to pay top prices—perhaps to bid prices up higher than they’d otherwise go—even if this goes against their judgment. These same investors are also apt to flee when prices hit their lows, forcing the manager to sell at the bottom.

What’s more, managers of these types of theme funds sometimes gravitate toward speculative stocks and recent new issues, two areas that can expose you to extra risk.

Of course, these theme funds can prosper for months or years. But they rarely generate enough profit to justify their underlying risk.

Here are five more tips for selecting long term mutual funds:

1. Beware of buying vaguely described mutual funds

Get rid of mutual funds that show wide disparities between the mutual fund’s portfolio and the investments that the sales literature describes. Many mutual fund operators describe their investing style in vague terms.

It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at a mutual fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. When the mutual fund takes on a lot more risk than you’d expect, our advice is to get out.

2. Avoid buying mutual funds that trade in derivatives

Some funds are set up to profit by trading in derivatives, based on studies of what would have paid off in the past five years, for example. But other market participants can also access that information. So, things are unlikely to work quite the same way for the mutual fund’s performance over the next five years.

In the long run, derivatives trading is what mathematicians refer to as a “negative-sum game”: one player’s gain is another’s loss, minus commissions and other costs. In the end, trading derivatives costs you money.

3. Avoid mutual fund managers who trade heavily

Some of the most dangerous funds are those run by managers who honestly believe they can increase their performance by frequent in-and-out trading. Many of these managers fail to realize how close their mutual fund’s performance comes to disaster each year, until disaster finally strikes.

If you add up the fund’s losses on bad stocks at the end of a given year, they may amount to a high percentage of their fund’s assets (25%, for example). That may seem perfectly acceptable to the mutual fund manager, so long as the profits on their winning trades are significantly higher than that (for example, 75% of assets).

If the mutual fund manager guesses wrong a few times, however, it’s all too easy to reverse those figures: that is, have losses totalling 75% of assets and profits totalling 25%, so that the mutual fund loses 50% of its capital. If the manager delves into low-quality or highly volatile choices, as heavy traders are apt to do, then the mutual fund’s performance can drop.

4. Avoid buying mutual funds with a lot of dead weight

When a fund’s portfolio shows page after page of obscure speculative stocks, particularly thinly traded ones or recent new issues, you can be exposed to a concealed, but very serious, risk. If the market drops, and too many investors want their money back, the mutual fund may have to sell some of its assets to raise cash.

Obscure speculative holdings will prove hard, if not impossible, to sell when prices are generally low. This may force the mutual fund manager to dump his best holdings at a time of market weakness.

5. Avoid buying mutual funds with anonymous managers

This includes buying mutual funds run by committees. The trouble here is that the brains of the mutual fund may leave, and investors would never know it until they saw the drop in their mutual fund’s performance. Leaving the investment decisions to an anonymous group of people is never good for the health of long-term mutual funds.

Are you invested in any long-term mutual funds? What sectors are they in? Share your thoughts and experience with us in the comments.