I'm trying to educate myself in asset allocation with respect to retirement investing. I have about 14-16 yrs. til retirement but really haven't figured out what's the most important factors to consider when choosing a mutual fund. I know Bogleheads invest in index funds. But what about funds such as Fidelity Contrafund. It's ten yr. return basically equals the S&P but it's expense ratio is higher than an S&P index fund. But Morningstar rates the Contrafund at five stars. I don't get it. If a fund's performance over a given timeframe exceeds the S&P index, accounting for fees and expenses, isn't that fund a good investment over an index fund?
Generally not. If you look at all large-cap domestic equity funds (because that's 87% of what you're talking about when you talk about the Contrafund), including those that no longer exist because they did so poorly, and either were terminated or buried inside some other fund, the index funds do better. The fact that we're talking about the Contrafund now means that its advantage is baked into its value already. A few years ago we were talking about Puritan, or BRK, or whatever. The point is that looking back you can always find funds that did better than the index, but over time generally funds falter or simply cannot maintain their advantage. In many cases, it is because a fund's success makes it too big to apply its strategy effectively.
So, in a nutshell, you could get lucky: Contrafund may actually return more than its benchmark index over the fifteen years until you retire plus the fifteen to thirty years it'll take for you to drain its assets (many people forget about the fact that they're going to be heavily invested for at least the first half to two-thirds of their retirement, to fund that last third of retirement). Alternatively, it may have had its day and the index fund will start beating it soon, simply because whatever advantage the Contrafund could have stemming from the work of its professional analysts will be eaten away by its higher fees.
However, I'm not convinced that that logic applies reliably beyond the definitively efficient markets, such as large-cap domestic equities. I think small-cap is pretty efficient as well. I'm not so convinced that international equities is. And I don't think you can ensure you're going to get the best returns from your international allocation by investing in international index funds. I think, at least for now, professionals have something to offer in that regard. And I'm also convinced that the bonds market is so screwed up right now that I don't want to be in a bonds index fund either.
Full disclosure: I have about 50% of my large-cap domestic equities position in index funds, almost 30% in "other Vanguard funds" (such as Wellington). Another 10+% comes from one managed fund that I'm invested in heavily, for its expertise in finding value in Asia and Europe (but the fund still holds a good amount in domestic equities as well). And the remaining 10% are in legacy holdings for which I haven't found a good time (tax-wise) to liquidate and roll into something "better". By comparison only 10% of my international equities position is in index funds.