Here are 4 rules we stick to when we’re researching mutual funds to include in our newsletters and investment services. While there is never any guarantee of a mutual fund’s performance, following these rules should help you avoid making poor choices.

(For more on our fund-picking strategy, including our top ten fund picks, be sure to download our new special report, “Mutual Funds Canada: Inside the Top 10 Canadian Mutual Funds.”)

Avoid 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.

Avoid mutual funds whose managers pride themselves on trading 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.

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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.

Avoid 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.

Avoid funds with anonymous managers

This includes 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.

If you invest in mutual funds, make sure you don’t miss our latest special report, “Mutual Funds Canada: Inside the Top 10 Canadian Mutual Funds.” Click here to learn how you can download your copy right away.