How to Choose a Mutual Fund

How to Choose a Mutual Fund
The average mutual fund investor tends to fare significantly worse than the average mutual fund. How so? Well investors tend to let their emotions get the best of them – and dash in and out of funds at precisely the wrong moments. You know how it goes -- you want to buy when the market is hot and sell when it’s going to pieces. If you simply create a well-diversified portfolio of stock and bond funds and left them alone, you’d be much better off.

As long as you do your homework upfront…

Everyone’s tempted to base their fund buying decision on a fund’s performance, but that shouldn’t be the only factor you consider. Today’s star performer could easily become tomorrow’s laggard. Here are some guidelines:

1.) Fit. To get started with mutual funds, you need to figure out what mix of stocks and bond funds best suits your objectives. The right mix depends on how long you’re going to invest your money for and how much risk you like to take on. Check out this asset allocation calculator which helps you figure out what types of investments you should make. Once you figure out your strategy, you’re ready to evaluate which particular funds will help you achieve its goals.

2.) Index Funds versus Active Funds. Consider whether you’re comfortable using index funds or whether you want to use actively managed funds.

Index funds are much cheaper to run, since, for one, the managers don’t have to travel around researching companies trying to find the right stocks to buy.

That cost advantage gives index funds a huge leg up compared with their actively-managed counterparts. Take, for instance, an actively-managed fund that skims 1.3% of your invested dollars off the top of your money pile each year. Instead of investing in that fund, you could have invested in an index fund that charges just 0.10% a year in fees. That means the active manager needs to do at least 1.2% better than the index fund each year to make up the difference. It ain’t easy, and most active fund managers fail at this task.

You probably have better things to do than spend hours upon hours tracking fund performance and searching for good active managers. But if you take pride in picking out active funds, then go for it. Just realize that your chances of picking funds that actually beat the market, or the index fund that tracks it, are really slim over the long haul.

Sometimes you might not have a good index fund to invest in – not all retirement plans offer them (if your 401k doesn’t offer index funds on the investment menu, ask your employer to add them).

3.) Expenses. This is the one piece of your fund’s performance you can control since costs directly impact your returns over time. There are a few different kinds of fees you need to consider:

a.) Expense Ratio - is the money skimmed from your account that goes towards paying a fund’s total annual expenses. It’s expressed as a percentage of a fund’s net assets. So, if you’re in a fund with an expense ratio of 1.0%, and you have $3,000 invested in that fund, you’ll pay $30 a year in expenses. An expense ratio of 0.10% will only cost you $3.

The average actively-managed fund carries an expense ratio of 1.31%, while the average index fund costs 0.74%, according to Morningstar. But paying the average doesn’t necessarily mean you’re getting a good deal. You can get the most bang for your buck with broad-market index funds: the Vanguard Total Stock Market Index, an index fund that tracks an index (MSCI US Broad Market Index ) representing the entire U.S. stock market, carries an expense ratio of 0.19%. Meanwhile, the Fidelity Spartan Total Market Index, which tracks another index that represents the entire stock market, is even lower at just 0.10%.

b.) Load - is a sales charge attached to the purchase or sale of a mutual fund. Try to avoid these fees. They usually pay financial professional involved in the transaction, like a stockbroker. If a broker is selling a fund, it’s most likely a load fund.

A “front-end load” is charged when you buy shares of the fund, whereas a deferred, or “back-end load,” is levied when you sell your shares. Back-end loads may gradually decline and disappear the longer you hold the fund, but another type of sales charge typically offsets that.

The average front-end load clocks in at 5.01%, while the average back-end stands at 4.67%, according to Morningstar.

There is such thing as a no-load fund – which is a mutual fund where shares are sold without a commission of sales charge. These funds are usually sold by the mutual fund company rather than a second party.

c.) 12b-1 fees - were first charged by mutual fund companies to investors in the 1980’s when mutual funds were new and struggling; they covered costs associated with marketing and distributing the fund. Today, the mutual fund industry is doing just fine; the fee is now paid to brokers for selling the funds (much like a load). It’s included in the fund’s expense ratio.

Funds with 12b-1 fees greater than 0.25% are also considered load funds, according to the Investment Company Institute, a mutual fund trade group.

d.) Redemption fees - are charged when a shareholder exits a fund before a certain period of time elapses; they were installed to discourage rapid trading in and out of funds. The time period varies, but is usually 30, 180 or 365 days. The fee doesn’t go into the fund company’s coffers, but into the fund itself, according to Morningstar.

4.) Fund company and manager. How long has the fund (or index) been around? How long has the manager been running the fund? Does the fund company have a long-standing solid reputation?

5.) Volatility. Are there a lot of sharp zigs and zags in the fund’s performance or are returns more consistent over time? All funds take on a certain degree of risk, but volatile funds tend to be more risky. You can usually find historical returns on the fund company’s website or on a site like Morningstar.com (you can find returns and other basic information for free, though more detailed information requires a subscription).

6.) Performance. Be sure to look at the funds’ 3-year, 5-year and 10-year records. You don’t want to invest in an unproved fund that only has a year or two of performance history.

Compare the fund to its relevant market index, otherwise known as its benchmark. This is a yardstick against which investors evaluate a fund’s performance. Index funds try to match the benchmark while actively managed funds try to beat it (make sure they’re beating in NET of fees.) A common benchmark for U.S. stock funds is the S&P 500 index fund. The Lehman Brothers Aggregate bond index is often used as a benchmark for U.S. bond funds.

Check out how the fund has weathered downturns in the market (you can tell when the downturns were by finding where the benchmark veered south).

With newer funds, be wary of “back-tested” results, or results the fund may have achieved in the past if it existed at that time. The fund company could’ve have chosen the best time periods to make the fund look like it did better than it might actually have done.

7.) Taxes. If you’re investing in a taxable brokerage account (as opposed to your retirement accounts, like an IRA or 401k, where you generally don’t pay taxes until you start withdrawing money) you’ll want to evaluate the fund’s portfolio turnover, which can trigger taxable gains.

Portfolio turnover is a rough measure of how often a fund manager buys and sells securities within the fund. The more often a portfolio turns over, or churns, the more trading costs it incurs (trading costs are fees the fund pays to buy and sell its shares). It may also trigger taxable capital gains, which it distributes to you at the end of the year; you report those profits (if any) to the IRS and may owe taxes.

That’s why if your fund is in a taxable account, you generally want to look for funds with turnover of less than 25%, says Christine Benz, director of mutual fund analysis at Morningstar, preferably in the single-digits. A 100% turnover rate means assets equal to the fund’s entire portfolio were sold during the year. Lower turnover indicate the manager is using a longer-term strategy of buying securities and then holding them for a while (buy-and-hold, in investing language). Taxable investors also want to be on alert if a fund’s manager changes, she adds, because the new manager might sell securities with big gains.

Naturally, some funds are more prone to higher turnover: a small-cap growth fund chock full of volatile stocks is going to experience a lot more churn than a retirement-focused fund.