How to choose the best funds for your 401(k)

@CNNMoney December 9, 2011: 6:15 AM ET

(MONEY Magazine) -- I'm 31 and dissatisfied with the funds I now own in my 401(k). So I want to shift my money to different funds within the plan. When making this decision, which do you think I should focus on more: the funds' expenses or the returns the funds have earned? - C.H.

Clearly, no single metric is going to tell you all you need to evaluate a fund. But given the choice you've posed, I'd definitely put more emphasis on the fees a fund charges than the returns it's earned.

Why?

Well, for one thing returns alone are tough to evaluate. They can be up big time in some years, way down in others and flat in still other periods. But that probably has more to do with changing market conditions than a manager's skill or lack of it.

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And even if you see a fund with attractive returns relative to its peers, that doesn't necessarily mean the manager is some sort of wiz kid. It could just reflect the fact that the manager is focusing on a narrower selection of companies than other funds in the same investment category and that niche happens to be doing well. Or maybe instead of adhering strictly to the fund's stated strategy, the manager is straying a bit to juice returns, say, moving into mid- or small-caps when the fund's true mandate is large companies. Or it could it be that the manager is just taking a lot more risk in pursuit of loftier gains.

Trouble is, that while all these strategies can generate stellar performance, they can also backfire, leading to lackluster returns or losses.

Fees, on the other hand, tend to persist. If a fund has fat expenses today, it's unlikely the charges will slim down in the future. And funds that take a more skinflint approach on fees tend to stay that way. So I think you can count on fees more than returns.

And while I wouldn't go so far as to say that it's impossible for a fund saddled with onerous expenses to generate competitive returns, I can say it's more difficult for such a fund to do so.

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It's a bit like having two runners in a marathon that are identical except one has running shoes that weigh a pound more apiece. I don't care how good an athlete someone is. Sooner or later, that extra weight is likely to slow him down.

And, indeed, that's exactly what fund stats show. When I divided large-cap funds into four groups based on the size of their fees for a story last year on questions people should ask before investing their dough, I found that the 15-year annualized return of the low-fee group was a full 1.3 percentage points higher (7.6% vs. 6.3%) than the return of the high-fee group. That translates to a $5,000 difference over 15 years on a $10,000 investment. So we're talking real money.

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Fortunately, 401(k) investors who want to follow my advice and focus their attention on a fund's fees may have an easier time doing so starting next year. That's because a long-discussed (make that too long) rule requiring 401(k)s to provide better fee disclosure will finally become reality by the end of May.

As I noted in a previous column the disclosure you'll get is far from ideal. But it's a decent start, and for many 401(k) investors should shed new light in an area where sunshine is desperately needed.

Quick savings calculator

What's more, the fact that fee information will be more easily accessible for all to see (including plan sponsors who are also often in the dark about what they're paying) should ultimately create pressure on investment firms to keep costs down.

Ask the Help Desk your money questions

So as you sift through the fund choices in your plan, by all means look at how they've performed, and especially at the level of risk they take. Plug the fund's name or ticker symbol into the Quotes box at the top of the page at Morningstar.com and then click on the Ratings & Risk tab, you'll get a slew of different risk indicators.

And you'll certainly also want to make sure you're putting together funds that work as a coherent portfolio by following the principles of asset allocation.

For a guide, you might also check out the stocks-bonds mix of target-date retirement fund for someone your age (probably a 2045 fund).

But when it comes down to making final choices, I'd lean more toward the funds with lower expenses. Because the less you fork over in fees during your career, the bigger the nest egg you'll likely have to support you in retirement. To top of page

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