(Ed. note: This is adapted from 'Funds you can trust' in the November issue of Money magazine. Subscribers can read the complete text by clicking here.)
NEW YORK (Money magazine) - After three long years of rotten returns, a rolling wave of scandals has now thrown into question whether mutual fund managers still retain enough basic integrity to deserve your trust.
Here are 10 commandments for investors who want to keep the faith but not get burned:
1. Thou shalt not covet
The party line in the money-management business is that to make any money a fund company needs to charge a management fee of at least 1 percent. But that's bunk.
There's no good reason for a fund to charge annual expenses higher than these: for investment-grade bonds, 0.75 percent; large and mid-size U.S. stocks, 1 percent; high-yield (junk) bonds, 1 percent; small U.S. stocks, 1.25 percent; foreign stocks, 1.5 percent.
Some fund families with generally low expenses: American Century, American Funds, Bridgeway, Fidelity, Janus, T. Rowe Price, Vanguard.
2. Thou shalt sup at thine own table
Portfolio managers often invest the bulk of their net worth not in the funds themselves but in the management company that runs them. That gives them a greater stake in fattening the management fees on the funds than in maximizing the investment returns of the funds.
But when the fund managers are themselves the biggest shareholders in their funds, they are highly likely to think like investors -- because they are.
Some fund families with strong insider participation: Bridgeway, Davis, FPA, Longleaf, Tweedy Browne.
3. Thou shalt not be a glutton
It's like a broken record: Little fund gets hot, fund company promotes performance, fund goes cold.
Small funds have the flexibility to buy a carefully selected group of small stocks, keep brokerage costs low and make sure the portfolio gets lots of attention. But when hundreds of millions of dollars pour in too fast, the manager often has to chase bigger stocks that are no longer cheap, hiking brokerage costs and saddling him with far more stocks than he can study thoroughly. That hits performance like a bucket of ice water.
Some families that tend to close funds before they get too big: Bogle, Bridgeway, Numeric, Longleaf, T. Rowe Price, Vanguard.
4. Thou shalt not boast
If the most important thing to a fund's managers is signing up new investors, that's a sign that they care more about increasing their own fee income than about improving your investment results.
Instead, you want a fund run by people who soft-pedal their past returns and keep future expectations realistic. An excellent way to see how the managers think about performance is to go back and read the fund's report from year-end 1999; it should sound notes of caution, not blasts of bravado.
Some particularly modest families: Mairs & Power, Torray, Vanguard.
5. Thou shalt be pure in heart
A few fund companies are so proud of what they stand for that they display their mission statements for all to see.
Bridgeway's Web site (www.bridgewayfund.com) features pages of detail on how the firm works to cut costs for its investors; it also runs the full text of Bridgeway's code of ethics, which prohibits employees from trading stocks for their own accounts, receiving shares in initial public offerings and accepting gifts worth more than $50. Bridgeway also donates half of its profits to charity and caps the compensation of its president, John Montgomery, at seven times the pay of its lowest-earning employee.
This is what corporate-governance experts call transparency. When you can see right inside a firm, you can tell what it's made of.
Some particularly open families: Bridgeway, Longleaf.
6. Thou shalt not be sheep
Over the past decade most fund managers have become increasingly sheeplike. Open the portfolio of any U.S. large-company stock fund and you will find the same names with mind-numbing frequency: General Electric. Microsoft. Pfizer. Wal-Mart. Citigroup. Johnson & Johnson. Cisco.
If you don't buy an index fund, you should forage around for a fund that dares to be different. Look for a manager whose "R-squared," a statistical measure of how closely he tracks the market, is below 90 percent. (You can find that number under Risk Measures in the fund profiles at www.morningstar.com. You also can get a Morningstar Snapshot report by punching in a fund ticker symbol in the quote box in the upper left of CNN/Money.)
Some funds with independent streaks: Clipper, Dodge & Cox, Fidelity Contrafund, Oakmark, Selected American, T. Rowe Price Equity-Income.
7. Thou shalt be patient
Odd, isn't it, that most fund managers always seem to own the same stocks -- and yet they constantly trade them? According to Morningstar, the average large-growth fund has a 184 percent turnover rate, meaning that it holds its typical stock for only 6 months.
Finance professors Josef Lakonishok, Andrei Shleifer and Robert Vishny studied how funds would have performed if they had "frozen" their portfolios by doing no trading at all. On average, the funds would have increased their returns by three-quarters of a percentage point a year.
Some families with low turnover: American Funds, Dodge & Cox, Mairs & Power, Torray.
8. Thou shalt not tax
Is a fund going to work for you or for the IRS? A recent study by Lipper found that after all sales charges and expenses, equity funds earned an annual average of 6.79 percent over the 10 years ending in 2002.
But taxes ate up two percentage points of performance, leaving the typical investor with just a 4.8 percent yearly return. In short, careless or indifferent management by fund companies has cost taxable investors nearly one-third of their total return over the past decade.
Some tax-friendly funds: Fidelity Dividend Growth, Jensen, Mericdian Growth, T. Rowe Price Blue Chip Growth, Third Avenue Value, Vanguard Primecap.
9. Thou shalt scourge the greedy
Normally you want to avoid a fund with extra fees, but a "short-term redemption fee" is one charge you should cheer. Anyone who can't hold on to a fund for at least 90 days at a time is not an investor; he's a speculator, and he deserves to be punished for raising your costs and lowering your returns. That's why good funds charge up to 2 percent in short-term redemption fees -- and why the SEC should drop its silly objection to even higher penalties.
10. Thou shalt love thy neighbor as thyself
While most fund companies like to call themselves families, it's fair to ask what sort of family would treat its own members like complete strangers.
If the only cause for loyalty a fund has ever given you is its hot returns, then your faith in the fund will always be as perishable as its performance. If, however, the fund company reaches out and makes you feel like part of a community, you are more likely to ride out any performance bumps.
Some families that communicate well: Aquila, Ariel, Clipper, FAM, IPS Millennium, Longleaf, Oakmark, Third Avenue, Tweedy Browne.