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They don’t advertise. Just as Plato says in The Republic that the ideal rulers are those who do not want to govern, the best fund managers often behave as if they don’t want your money. They don’t appear constantly on financial television or run ads boasting of their No. 1 returns. The steady little Mairs & Power Growth Fund didn’t even have a website until 2001 and still sells its shares in only 24 states. The Torray Fund has never run a retail advertisement since its launch in 1990.

What else should you watch for? Most fund buyers look at past performance first, then at the manager’s reputation, then at the riskiness of the fund, and finally (if ever) at the fund’s expenses.8

The intelligent investor looks at those same things—but in the opposite order.

Since a fund’s expenses are far more predictable than its future risk or return, you should make them your first filter. There’s no good reason ever to pay more than these levels of annual operating expenses, by fund category:

Taxable and municipal bonds: 0.75%

U.S. equities (large and mid-sized stocks): 1.0%

High-yield (junk) bonds: 1.0%

U.S. equities (small stocks): 1.25%

Foreign stocks: 1.50%9

Next, evaluate risk. In its prospectus (or buyer’s guide), every fund must show a bar graph displaying its worst loss over a calendar quarter. If you can’t stand losing at least that much money in three months, go elsewhere. It’s also worth checking a fund’s Morningstar rating. A leading investment research firm, Morningstar awards “star ratings” to funds, based on how much risk they took to earn their returns (one star is the worst, five is the best). But, just like past performance itself, these ratings look back in time; they tell you which funds were the best, not which are going to be. Five-star funds, in fact, have a disconcerting habit of going on to underperform one-star funds. So first find a low-cost fund whose managers are major shareholders, dare to be different, don’t hype their returns, and have shown a willingness to shut down before they get too big for their britches. Then, and only then, consult their Morningstar rating.10

Finally, look at past performance, remembering that it is only a pale predictor of future returns. As we’ve already seen, yesterday’s winners often become tomorrow’s losers. But researchers have shown that one thing is almost certain: Yesterday’s losers almost never become tomorrow’s winners. So avoid funds with consistently poor past returns—especially if they have above-average annual expenses.

The Closed World of Closed-End Funds

Closed-end stock funds, although popular during the 1980s, have slowly atrophied. Today, there are only 30 diversified domestic equity funds, many of them tiny, trading only a few hundred shares a day, with high expenses and weird strategies (like Morgan Fun-Shares, which specializes in the stocks of “habit-forming” industries like booze, casinos, and cigarettes). Research by closed-end fund expert Donald Cassidy of Lipper Inc. reinforces Graham’s earlier observations: Diversified closed-end stock funds trading at a discount not only tend to outper-forms those trading at a premium but are likely to have a better return than the average open-end mutual fund. Sadly, however, diversified closed-end stock funds are not always available at a discount in what has become a dusty, dwindling market.11

But there are hundreds of closed-end bond funds, with especially strong choices available in the municipal-bond area. When these funds trade at a discount, their yield is amplified and they can be attractive, so long as their annual expenses are below the thresholds listed above.12

The new breed of exchange-traded index funds can be worth exploring as well. These low-cost “ETFs” sometimes offer the only means by which an investor can gain entrée to a narrow market like, say, companies based in Belgium or stocks in the semiconductor industry. Other index ETFs offer much broader market exposure. However, they are generally not suitable for investors who wish to