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Investor Psychology

Tame Your Funds' Worst Instincts

What you can do to combat their shortcomings.

In the title of his classic, 1940 book satirizing Wall Street, Fred Schwed Jr. asked, Where Are the Customers' Yachts? His point was that while plenty of brokers got rich, few of their customers did. Arguably, you could ask the same question of the mutual fund industry -- one of the most profitable businesses on the planet -- and its clients.

Don't get me wrong. By providing management, diversification and convenience, funds are the most appropriate vehicle for most investors. But funds have flaws that work against their clients' best interests. Below I list some of those shortcomings and what you can do to combat them.

First, management fees are too high. Moreover, few sponsors tie fees to results, and many charge the same percentage amount regardless of a fund's size. Solution: Consider low-cost index funds and shop around for families (such as Vanguard, Dodge & Cox and American Funds) that don't charge an arm and a leg. Give extra credit to firms -- such as Vanguard, Fidelity, Bridgeway and Janus -- that base management fees on performance.

In an inherent conflict of interest, sponsors allow their funds to grow too big, to the detriment of shareholders. Solution: Look for families, such as Longleaf Partners and Dodge & Cox, that aren't reluctant to close funds to new investors. And be wary of firms that announce that they are closing a fund well ahead of the actual shutdown date; such a move smacks of a last-minute asset grab.

Companies tend to launch new funds when an investment category is hot -- think emerging-markets funds in the early 1990s and Internet funds in the late '90s. Favor families, such as FPA, Longleaf and Dodge & Cox, that have long histories and concentrate on a small number of funds.

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Managers care too little about the tax consequences of their actions. Peruse a fund's portfolio turnover rate and the gulf between before- and after-tax returns. When investing in a regular account, favor index funds, tax-efficient funds and funds whose managers profess to pay attention to taxes and have the record to back it up.

Managers tend to focus more on how they perform relative to a benchmark rather than to the absolute amount they earn. But a manager who loses 35% when the stock market tumbles 37% is doing you no favor. My advice: Research how funds do in up and down markets. I prefer funds that share most of the upside in a bull market but a much lower percentage of the losses in a bear market. For instance, Steve Romick's FPA Crescent has enjoyed 76% of the market upside since its June 1993 inception, but has suffered only 52% of the downside.

It may come as little surprise that many of the sponsors I mentioned above -- Vanguard, Fidelity, Dodge & Cox, Longleaf and FPA -- are well represented in the Kiplinger 25, the list of our favorite no-load funds. It's not a coincidence.