Rules you need to follow when buying mutual funds for the long-term success of your portfolio.

Buying mutual funds should be done with the long term in mind. Find a sound fund that holds good stocks and stick with it.

There are, of course, thousands of mutual fund choices available at any time. But remember that most funds are set up because a fund sponsor has a saleable idea. It may or may not be a good investment idea, and these days it often isn’t. That’s because the marketing department is in charge at many mutual fund organizations. This leads to management decisions that are mainly aimed at selling new units of mutual funds, rather than safeguarding the interests of the investors who are buying mutual funds.

Here are our rules for buying mutual funds:

1. Get out of buying “theme” mutual funds

If the mutual fund’s theme seems to be plucked from recent headlines, stay away. It pays to stay out of narrow-focus, faddish funds, all the more so if they’ve come to market when the fad dominates the financial headlines.

Theme funds like these face a double disadvantage, because they appeal to impulsive investors who pour their money in just as the fad hits its peak. This forces the manager to pay top prices— perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. These same investors are also apt to flee when prices hit their lows, forcing the mutual fund manager to sell at the bottom and lowering the mutual fund’s performance. But when a fad fades, as they all do, the fund’s liquidity dies out with it. The manager may have to dump the mutual fund’s holdings when demand is at its weakest, forcing prices lower than they would otherwise go.

2. Get out of buying bond mutual funds

Many bond funds built great performance records in the last decade. But this was a function of the trend in interest rates; when rates fall, bond prices go up. Interest rates are low right now, but could move upward over the next few years as the economy recovers or in response to inflation fears. This is another way of saying that bond prices could fall.

When bonds yielded 10%, perhaps it made some sense to buy bond funds and pay a yearly MER of, say, 2%. Now that bond yields are down closer to 4%, it makes a lot less sense, and has a greater impact on your mutual fund’s performance.

The bond market is highly efficient, and we doubt that any bond mutual fund’s performance can add enough to offset its management fees. In addition, investing in a bond mutual fund exposes you to the risk that the manager will gamble in the bond market and lose money.

Bonds are attractive for predictable income, and as an offset to the stocks in your portfolio. But it’s cheaper to buy bonds directly than to do so through a bond mutual fund. If you want capital gains, buy stocks or stock-market mutual funds.

3. 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.

4. 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.

5. 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 a heavy trader’s losses 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.

6. 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.

7. 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.

Investor bonus: Why we prefer ETFs over buying mutual funds

1. ETFs are less expensive to hold. ETFs give you a low-cost way to invest in a narrow market segment. That’s typically cheaper than investing in a mutual fund with a similar focus. With fees as low as 0.10% a year for ETFs vs. mutual funds that can charge you 2% to 3% or higher on their fund. ETFs can save you a lot of money and boost your return if you are investing over time.
2. ETFs trade on stock exchanges, just like stocks. That’s different from mutual funds, which you can only buy at the end of the day at a price that reflects the fund’s value at the close of trading.
3. Low turnover. Shares are only added or removed when the underlying index changes. As a result of this low turnover, you won’t incur the regular capital gains taxes generated by the yearly distributions most conventional mutual funds pay out to unitholders.

One interesting note about buying mutual funds comes from the Dalbar organization.

This U.S. research firm’s studies studies of top performing mutual funds show most of their investors who jump in at the top will lose money or make negligible returns. That’s because most investors in a top performing fund only buy into the fund after it has already made big gains. Investors also tend to sell former top performing funds only after a major slump in the value of their holdings. When you chase investment performance, it’s all too easy to buy at the top and sell at the bottom.

What has your experience been buying mutual funds? Has been profitable? Share your experience with us in the comments.

Note: This article was originally published in 2009 and has been updated.