Fancy restaurants and luxury-car makers cater to customers who are willing to pay extra for a product they consider superior.  For mutual-fund investors, the less-expensive choice is often the better bet.  That rule of thumb has helped drive the rise of passive funds, which are designed to track indexes and generally charge lower fees than funds that try to beat a stock-market benchmark. Since the returns of funds that follow the same index should be similar, price is a major consideration.  Yet the rule also applies when choosing among similar actively managed funds, experts say.  “If it’s a jump ball, you go with lower fees,” says Michael Mauboussin, head of global financial strategies at Credit Suisse. But he adds, “It doesn’t appear to be the only thing you can pay attention to.”  Other factors to consider besides price include a fund’s long-term performance and whether a fund’s best years occurred long ago, or under the watch of a different manager. Another issue is whether the fund manager seems to be trying to beat a benchmark index, such as the S&P 500, or just collecting a fee for building a portfolio that looks a lot like an index.  The case for index funds is strong, but there are legitimate reasons to consider buying an actively managed fund. Investors may want to complement a portfolio consisting largely of index funds, or because they want a chance to do better than the market and accept the risk of underperformance that goes hand-in-hand with stock-picking.  Clayton Eley, a 64-year-old retiree, says the majority of his stock portfolio is in index funds but that he also invests in a handful of active funds. Mr. Eley, who lives in Jonesborough, Tenn., explains his motive simply: “You pursue growth.”  Investors who worry that the six-year bull market could soon end also may believe that active managers will fare better in a downturn, though they may be disappointed.  Here is how to be smart about choosing an active fund:  It is important to understand exactly why costs are crucial.  The returns of active funds vary considerably—some do better and some do worse than their benchmarks. Whether the managers win or lose, they still charge often substantial fees.  Last year, active stock mutual funds charged investors average annual fees of 0.85%, or $85 on a $10,000 investment—down from 1% in 2005 and 1.09% in 1995, according to Morningstar, an investment-research firm based in Chicago. The comparable figure for index funds is 0.13%. (Both numbers are weighted by assets, so bigger funds count more than smaller ones.)  One reason: Active funds have to hire analysts and data-crunchers to help determine which stocks to buy or sell, and when—expenses for which an index fund has no need since it typically holds almost every stock in the index.  The problem, from an investor’s perspective, is identifying the active managers whose returns might justify their fees, particularly if the fund comes with a sales charge, or “load.”  Many funds that outperform over a short period struggle to repeat the feat in the long run. Figuring out which manager got lucky and which manager has skill is tough.  “It’s incredibly difficult to judge the quality of a fund ahead of time,” says Russ Wermers, a finance professor at the University of Maryland.  As a result, lower costs generally put investors in a stronger position to log higher total returns, which include price changes and dividends.  Active funds that buy stocks in large U.S. companies and that rank among the least expensive 10% of peers generated an average annual return of 5.3% over the 15 years ended Dec. 31, 2014, according to an analysis of Morningstar data by the Bogle Financial Markets Research Center.  By contrast, similar funds that rank among the most expensive 10% returned an average annual 3.8% over the same period.  The Bogle center is funded by fund giant Vanguard Group, based in Malvern, Pa., which has championed index funds but also runs active funds that carry relatively low annual expense ratios, or fees.  “If you want to go to actively managed funds, go fishing in the low-cost end,” says John Bogle, who founded Vanguard and now heads the center.  Just prepare for murky waters.  It isn’t difficult to find active funds that outperform less-expensive funds that buy similar kinds of stocks.  For example, the $1.2 billion Fidelity Value Discovery Fund and the $18.7 billion Vanguard Windsor Fund are both in Morningstar’s “large value” category, which typically means funds that hold stocks that are seen as undervalued.  Both hold mainly U.S. stocks, but have some foreign holdings; at year-end, one stock—Wells Fargo—was among the top 10 holdings in both funds.  The Fidelity fund charges annual fees of 0.80% and the Vanguard fund charges 0.38%. Despite its higher fees, the Fidelity fund outperformed the Vanguard fund in three of the past five years, according to Morningstar.  Over the past 10 years, the average annual return is 8.4% for the Fidelity fund and 7.3% for the Vanguard fund, through Thursday.  At the same time, active funds that are less expensive often outperform similar rivals by a significant margin.  For example, the $1.1 billion Homestead Small-Company Stock Fund, run by Homestead Funds, in Arlington, Va., has generated average annual returns of 17.9% over the past five years and 11.6% over the past 10 years, through Thursday, according to Morningstar. The fund charges annual fees of 0.89%, which Morningstar categorizes as “low.”  No other no-load active fund that is in that category, “small blend,” and that is open to new investors has outperformed the Homestead fund over the past 10 years, through Thursday, according to Morningstar.  Given those kinds of differences, it isn’t a surprise that experts see cost as just one of several factors to consider when choosing among active funds.  Investors should weigh the fees that active funds charge “very heavily,” Mr. Bogle says. But, he adds, the price difference between an active fund that charges 0.50% and an active fund that charges 0.60%—a gap of 10 basis points, or hundredths of a percent—matters little.  “I wouldn’t do anything for 10 basis points. I’d pick the fund you want to pick,” he says. “At 20 basis points, I would think about it.”  There are some other issues to think about, as well, experts say.  First, make sure you are comparing similar funds by, for example, looking at their holdings and their investment philosophy.  You also may want to consider how active an active manager is, by looking at how closely the fund’s holdings mimic its benchmark index and by comparing the fund to a similar rival.  The comparison may not tell you much about which fund will do better. But it will give you some sense of what each manager is doing in exchange for the fund fee.  “If you’re going to pay a higher fee, you want a manager who’s actually active,” says Charles Pohl, chairman of Dodge & Cox, which is based in San Francisco and runs actively managed stock funds. “You should be sure you’re getting what you’re paying for.”  Look for fund companies that have expertise in the kind of fund that you are interested in and a commitment to keeping costs down, whether that is by keeping the expense ratio relatively low or by minimizing trading costs by avoiding excessive trading.  Keep in mind that the expense ratio also can go down over time, particularly if a fund’s assets grow and its costs can be more widely spread.  For example, the $60.7 billion Dodge & Cox Stock Fund had an expense ratio of 0.61% in 1994, according to the company, but now charges 0.52%. Morningstar classifies the fees of the fund as “low.”  Investors who want to own active funds also should be prepared to be patient, says Daniel Wallick, a principal at Vanguard who has written about the subject. “Make a commitment and hold it over time.”  Investors often obsess about returns, and performance is worth looking at—though it has little or no predictive power.  Study a fund’s returns both annually and over time, and see whether the fund has delivered consistently solid returns or whether it has outperformed wildly in some years and brought up the rear in others.  That could be important if you are likely to be rattled and tempted to dump a fund at the first sign that it is falling behind peers. If you are the kind of investor who has “a hard time riding through rough patches, that would be worth considering,” says Laura Lallos, a Morningstar analyst.  Similarly, check to see if a fund has a strong long-term record but has stumbled in recent years. That could be a warning sign, particularly if rival funds are thriving.  Funds that grow too large can have difficulty replicating earlier success, particularly in certain parts of the market, such as small and midsize companies, Ms. Lallos says.  It also could be worth asking the fund company what will happen if the returns of an active fund are disappointing. Fidelity Investments and Vanguard, for example, lower the fees of some funds that underperform, under certain circumstances.  Also check to see if there have been any changes in the fund managers, which could be important.  For example, two of the four managers of the Homestead Fund retired in January. The other two longtime managers remain with the fund, and they have been joined by a third manager, according to Steve Kaszynski, the firm’s chief executive.  The fund’s investment philosophy hasn’t changed, he says. And the firm still aims to keep costs low by, for example, avoiding the marketing costs that other firms may incur, according to Mr. Kaszynski. “We have no blimp,” he says.  Mr. Eley, the retired investor, says he bought shares about a decade ago in an active fund, the Vanguard Primecap Core Fund, in part because he was familiar with Vanguard’s low fees. The $7.7 billion fund, which now is closed to new investors, charges 0.50%, higher than many index funds but lower than many active funds.  “I’m a very frugal guy,” Mr. Eley says. But, he says, the potential to beat the market was “in the back of my mind.”  Write to Liam Pleven at liam.pleven@wsj.com
It’s tough to predict which active manager will beat the market. Here’s one way to improve the odds: Look for low fees.