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Does Your Mutual Fund Have a Competitive Edge?

Four traits that can separate advantaged funds from disadvantaged funds.

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It's championship time for the NBA and NHL, and sports fans are arguing over which of the remaining teams in each sport have that certain something that will put them over the top. Basketball's Los Angeles Lakers have a bona fide future Hall of Famer on their side--a definite competitive advantage--but the Boston Celtics arguably have three potential inductees. The Chicago Blackhawks, who are leading the Stanley Cup Finals against the Philadelphia Flyers, have lots of young talent, including a defenseman who chews slap shots and spits teeth, which on a hockey rink is a desirable trait. Meanwhile the Flyers have a knack for coming back when everyone writes them off.

A mutual fund doesn't have to hit fade-away jumpers with the shot clock expiring or sacrifice its incisors to save a goal. Yet, it's important to ask if a fund has a competitive advantage before investing. Just as Morningstar stock analysts focus on understanding whether a company has an economic moat that keeps rivals at bay, Morningstar fund analysts spend a lot of time figuring out whether a fund has a sustainable edge over its competition. In the spirit of this championship season, here are some enduring advantages with which a mutual fund can be endowed. It's not an exhaustive list and there could be some overlap between them, but finding a fund with a combination of these traits could lead you to a winner.

More for Less
Low cost is the simplest advantage. The less you pay up front, the more return you get over the long run. A quick screen in Morningstar's database shows that fixed-income funds, domestic-stock funds, and international-stock funds with below-average expenses have higher one-, three-, five-, and 10-year rankings in their respective categories. Numerous more detailed studies by Morningstar and others have shown low expenses to have a higher correlation with future returns than other factors, such as past performance, turnover, and risk. Yes, there are some funds with above-average fees that buck the trend, but there are far more high-cost funds that peter out and die. In general, investors increase the odds of getting more return for their money by paying less.

Dan Culloton has a position in the following securities mentioned above: VGHCX. Find out about Morningstar’s editorial policies.