Watch Out For These Red Flags If You Own A 'Garbage-y' Mutual Fund

Personal finance experts and investment experts are no strangers to jargon. Alpha, beta, downside capture, standard deviation, and downside capture are all terms they will soon be familiar with once you get them talking about mutual funds.

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It does happen, however, that things can skew in the opposite direction. Here's a tweet from Christine Benz, general manager of Morningstar's personal finance and retirement planning division.

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Benz told Trade Alfo, Make It that the term "garbage-y" is an apt description of hundreds of mutual funds that are expensive and offer poor returns.

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A "garbage fund" can be detected by its garbage-like characteristics and should be avoided by investors

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Fund performance is hampered by fees

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Although there have always been pricey funds, Benz anticipated that they would be less common now given that investor money has been shifting away from actively managed funds and toward passive techniques. According to Morningstar, investors have withdrawn money out of active funds in 11 of the last 12 years while passive funds have seen a consistent inflow of capital.

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Passive funds are less expensive to administer than funds led by highly compensated managers because they essentially repeat the performance of a specific index.

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Benz anticipated businesses would have terminated or consolidated "ugly ducklings" in their fund lineups given that investors in manager-led funds have been heading for the exits. There are still many ugly ducklings, she adds.

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High fees are the most obvious indication that you may own such a fund.

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According to Benz, "high charges are frequently enduring: If a fund is costly, our findings show that it is likely to remain costly. Furthermore, according to "our research," the high-cost subset of funds has a substantially lower chance of outperforming the low-cost subset.

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According to the most recent information from Morningstar, the average expense ratio for all mutual funds and exchange-traded funds in 2021 was 0.40%. The average fee for an active fund was 0.60%, compared to 0.12% for passive funds. Even now, you may still find strategies charging way above 1% if you browse a list of mutual funds.

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According to Benz, a high cost over time significantly disadvantages a fund. "So much of our data at Morningstar shows that high-cost funds struggle to overcome their expense ratios and produce returns that outperform their peers."

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Analyzing fund performance

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The red flags Benz mentions include high expense ratios. Moreover, sales costs that some businesses impose on when you buy or sell a fund might reduce performance. Another factor for concern is a high manager turnover rate.

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But, a fund's track record eventually speaks for itself. Examining how the fund has performed for investors over the long term can give you a decent sense of whether it is doing its job as an investment. However, past performance is no guarantee of future results.

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This calculation for index funds is rather straightforward. If you invest in a fund designed to track the performance of the S&P 500, it ought to be as near as possible to its benchmark and, ideally, charge a very small fee to do so.

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You'll need to conduct some research on active funds because they frequently strive to outperform a benchmark. Make sure to look past the kind of outcomes you typically see in fund advertisements, such as 1-, 3-, 5-, and 10-year returns. This is because trailing returns can be significantly impacted by recent performance.

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For instance, aggressively positioned funds that failed in 2022 currently most likely have dismal trailing returns, according to Benz. Nonetheless, these funds are often created to outperform the market during bull runs and lag during downturns.

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Although they may have enjoyed successful years in 2020 and 2021, last year's performance deviates from their long-term averages and may cast doubt on their ability to perform as investors hired them to under favorable market conditions, according to Benz.

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Instead, consider the performance of a fund over time. Using Morningstar's free tools, you may compare a fund's performance to its benchmark and to peer funds for each year going back to 2013. A fund that consistently outperforms its peers over extended periods of time is ideal.

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You need a fund that is operating at a minimum. The performance in 2021 and 2022 can be used as a "lens to judge what kind of fund you're working with" in order to achieve this, according to Benz.

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Although they underperformed in 2018, aggressive, high-growth funds should have theoretically outperformed in 2021. On the other hand, as the market plummeted, lower-risk methods ought to have fared better.