Do You Own a ‘Garbage-Y' Mutual Fund? Here Are the Red Flags to Watch Out for

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It's no secret that investing and personal finance experts are prone to jargon. Get them talking about mutual funds and you'll soon be in the land of alpha, beta, downside capture and standard deviation.

Occasionally, though, things skew in the other direction. Take a recent tweet from Christine Benz, director of personal finance and retirement planning at Morningstar.

"I've been screening for mutual funds on a major brokerage platform for the past few hours. My god there are still a lot of garbage-y funds out there," she wrote.

"Garbage-y" isn't exactly a term of art, but it is an apt way to describe hundreds of mutual funds that come with high price tags and deliver lackluster results, Benz told CNBC Make It.

Here's how to spot a "garbage-y" fund and why you should avoiding adding one to your portfolio

Fees are a drag on fund performance

There have always been overpriced funds out there, but Benz expected there to be fewer of them these days, given that investor dollars have been flowing out of actively managed funds and into passive strategies. Investors have pulled money from active funds in 11 of the past 12 years while passive funds have enjoyed a steady influx of cash, according to Morningstar.

Because passive funds merely replicate the performance of a particular index, they're cheaper to run than funds helmed by a well-paid manager.

Given that investors in manager-led funds have been headed for the doors, Benz assumed companies would have closed or consolidated "ugly ducklings" in their fund lineups. However, "there are still plenty of ugly ducklings out there," she says.

The No. 1 sign that you may hold such a fund: high fees.

"High costs are typically persistent: If a fund is expensive, our data suggest that it's likely to stay expensive," Benz says. Plus, "our research suggests that the high-cost subset of funds are much less likely to outperform than the low-cost subset."

In 2021, the average expense ratio among all mutual funds and exchange-traded funds was 0.40%, according to the latest data from Morningstar. The average passive fund charged 0.12%, while the average active fund charged 0.60%. Search through a list of mutual funds, and you can still find strategies charging well north of 1%.

A high fee puts a fund at a huge disadvantage over time, says Benz. "So much of our data at Morningstar points to the difficulty that high-cost funds have in overcoming their expense ratios to deliver peer-beating returns." 

How to parse fund performance

High expense ratios are just one of the red flags Benz points out. Other fees can eat into performance as well, including sales charges that some companies tack on when you buy or sell a fund. High manager turnover is another cause for concern.

But ultimately, a fund's track record speaks for itself. Past performance is no guarantee of future results, but examining how the fund has performed for investors over the long term can give you a good sense of whether it's doing its job as an investment.

For index funds, this calculation is pretty simple. If you buy a fund meant to track the performance of the S&P 500, it should get as close to its benchmark as possible and hopefully charge a very low fee to do it.

For active funds, which often aim to eclipse the performance of a benchmark, you'll have to do some digging. Be sure to look beyond the kinds of results you tend to see in fund commercials: 1-, 3-, 5- and 10-year returns. That's because recent performance can have an outsize effect on trailing returns.

"Right now, for example, aggressively positioned funds that bombed in 2022 probably have terrible trailing returns," says Benz. But such funds are typically designed to outpace the market during bull runs and lag during downturns.

They may have had excellent years in 2020 and 2021, but last year's results throw off their long-term averages, and could belie the fact that "they did what investors hired them to do in better market environments," says Benz.

Instead, look at what a fund does year in and year out. Morningstar's free tools allow you to see how a fund stacked up versus its benchmark, as well as peer funds in each calendar year dating back to 2013. Ideally, you want a fund that is consistently outperforming its peers over long periods.

At the very least, you want a fund that's doing its job. To this end, you can use the performance in 2021 and 2022 as "lens to assess what kind of fund you're dealing with," says Benz.

Aggressive, high-growth funds should have theoretically outperformed in 2021 but lagged last year. Conversely, lower-risk strategies should have held up better as the market fell.

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