How to Choose the Best Actively Managed Mutual Funds

An actively managed mutual fund is a pool of investments owned by its investors and selected by a fund manager, for which the manager receives an annual payment of a percentage of assets in the fund. When choosing a fund, important criteria are fund performance over time, risk-adjusted return, tax efficiency and management fees.

Price Performance

Compare the price performance of mutual funds using an objective source. Use a fund screener provided by your online broker or by an independent online screening service (see Resources). Screeners allow you to find funds with criteria you select. Consider screening for performance in the top 10 percent of all funds over one year, top 15 percent over three years and performance in the top 25 percent over five years. Setting performance standards over different time periods screens out volatile funds that may have high returns on investment over a one-year period but mediocre performance or greater losses over longer time periods.

Risk-adjusted return

Use a Sharpe ratio screening to evaluate the risk-adjusted returns of funds that meet your performance criteria. A Sharpe ratio compares the risk and return of the fund you're screening with the return on a risk-free investment, usually the 30 day T-bill. A Sharpe ratio of 1 or greater is good -- it means that for the increased risk of owning equities with greater price volatility than the T-bill, you are receiving an adequately compensating increased return. Additional risk-assessment screens you may want to perform are beta, alpha and standard deviation. Each analyzes risk from a slightly different mathematical perspective. If you are going to use just one of the risk screeners, however, the Sharpe ratio, which includes standard deviation in its assessment, is a good one.

Tax Efficiency

Screen your remaining mutual fund candidates for tax-efficiency. Almost all screeners have this capability. A fund manager who buys and sells equities frequently will generally increase your tax liability over a manager who buys and holds for longer periods, as equities held for more than a year are taxed at a lower rate than equities held over a shorter term. The specifics of the long-term tax advantage have varied as Congress has adjusted tax rates. In 2013, the long-term capital gain rate varies from zero percent to 20 percent, depending on income. A short-term capital gain is taxed as ordinary income at a rate that varies with income from 10 percent to 39.6 percent.

Management Fees

Screen for funds with low management fees. Management fees are subtracted from your return on equity. Studies have shown that over the long run, high management fees contribute to lower mutual fund performance. A 2009 study shows that fee percentages and returns on investment are inversely correlated -- the weakest funds charge the highest fees.

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About the Author

Patrick Gleeson received a doctorate in 18th century English literature at the University of Washington. He served as a professor of English at the University of Victoria and was head of freshman English at San Francisco State University. Gleeson is the director of technical publications for McClarie Group and manages an investment fund. He is a Registered Investment Advisor.

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