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July 18, 2007

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In general, a fund with strong long-term performance and long management tenure is going to have an unwieldy amount of assets under management, because investors chase performance (and have already beaten you to it).

So how can you pick a good actively managed fund? Simple: don't. Active management is bunk.

But if you really insist (or are forced to because of who your employer picked to run your 401(k)), here are a few good criteria:
1) Loads. Don't ever pay loads. For every load fund, there's a no-load fund that's just as good. Be especially wary of salesmen; a deal that comes to you is rarely a good deal.
2) Expense ratio. The lower the better. You can never be assured of future performance of the underlying investments, but you can get a good idea of the fees you'll pay. It may not sound like much, but 1/2% can make an enormous difference in the returns of long-term investments. You have to keep an eye on these to make sure they don't jack them up later too.
3) Other fees, such as minimum balance, transaction fees, etc.
4) Turnover. The lower the better. This is less of an issue in tax-sheltered accounts, but less turnover still indicates a manager more inclined to buy and hold.
5) Cash holdings. If it's supposed to be an equity fund, you don't want to see them holding much cash. That indicates that the manager is trying to time the market (or isn't quick enough at investing incoming money in equities). Time IN the market is more important than timing the market.
6) Style. That is, what does the fund invest in (e.g. small cap value, large cap, REITs, precious metals, emerging markets, etc.) You need to keep a close eye on your actively managed funds, because managers sometimes drift to other styles that have little resemblance to what you thought you were investing in.

I completely left performance off the list. I did that on purpose.

http://www.slate.com/id/2160236/

I just wanted to add one more thing for those who are forced into less-than-optimal fund families because that's who runs their 401(k) or 403(b): Do the best you can against that list, but no matter how bad it is, it's virtually always best to capture the full match your employer offers.

What about alpha? Aren't many active managers paid based on how they do compared to their benchmark indexes?

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