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The father of value investing, Benjamin Graham once wrote that making money on investing should depend “on the amount of intelligent effort the investor is willing and able to bring to bear on his task” of security analysis. He defined the intelligent investor as an enterprising individual that has the time and energy to do his or her own investment research.

In contrast to the intelligent investor is the defensive investor who would prefer to have another individual pick stocks, bonds and other financial assets on his or her behalf. Hiring a financial advisor is certainly one alternative, but most retail investors (and also many institutions) prefer to hire a manager through the purchase of a mutual fund.

Mutual funds can be a great addition to a portfolio, but with so many different options, it may be difficult to assess which products and strategies are best for any one individual. In some cases, mutual funds may not be the right fit, so it is important to know when other options may be more suitable.

Below is an overview of when it might be a good time to invest through the purchase of mutual funds.

Risk Tolerance

The first step in determining the suitability of any investment product is to assess risk tolerance. This is the ability and desire to take on risk in return for the possibility of higher returns. Though mutual funds are often considered one of the safer investments on the market, certain types of mutual funds are not suitable for those whose main goal is to avoid losses at all costs.

Aggressive stock funds, for example, are not suitable for investors with very low-risk tolerances. Similarly, some high-yield bond funds may also be too risky if they invest in low-rated or junk bonds to generate higher returns.

Investment Goals

Your specific investment goals are of one of the most important considerations when assessing the suitability of mutual funds, making some mutual funds more appropriate than others.

For an investor whose main goal is to preserve capital, meaning she is willing to accept lower gains in return for the security of knowing her initial investment is safe, high-risk funds are not a good fit. This type of investor has a very low-risk tolerance and should avoid most stock funds and many more aggressive bond funds. Instead, look to bond funds that invest in only highly rated government or corporate bonds or money market funds.

If an investor's chief aim is to generate big returns, she is likely willing to take on more risk. In this case, high-yield stock and bond funds can be excellent choices. Though the potential for loss is greater, these funds have professional managers who are more likely than the average retail investor to generate substantial profits by buying and selling cutting-edge stocks and risky debt securities. Investors looking to aggressively grow their wealth are not well suited to money market funds and other highly stable products because the rate of return is often not much greater than inflation.

Desired Income

Mutual funds generate two kinds of income: capital gains and dividends. Though any net profits generated by a fund must be passed on to shareholders at least once a year, the frequency with which different funds make distributions varies widely.

If your client is looking to grow her wealth over the long-term and is not concerned with generating immediate income, funds that focus on growth stocks and use a buy-and-hold strategy are best because they generally incur lower expenses and have a lower tax impact than other types of funds.

If, instead, she wants to use her investment to create regular income, dividend-bearing funds are an excellent choice. These funds invest in a variety of dividend-bearing stocks and interest-bearing bonds and pay dividends at least annually but often quarterly or semi-annually. Though stock-heavy funds are riskier, these types of balanced funds come in a range of stock-to-bond ratios.

Tax Strategy

When assessing the suitability of mutual funds, it is important to consider taxes. Depending on an investor's current financial situation, income from mutual funds can have a serious impact on an investor's annual tax liability. The more income she earns in a given year, the higher her ordinary income and capital gains tax brackets.

Dividend-bearing funds are a poor choice for those looking to minimize their tax liability. Though funds that employ a long-term investment strategy may pay qualified dividends, which are taxed at the lower capital gains rate, any dividend payments increase an investor's taxable income for the year. The best choice is to direct her to funds that focus more on long-term capital gains and avoid dividend stocks or interest-bearing corporate bonds.

Funds that invest in tax-free government or municipal bonds generate interest that is not subject to federal income tax, so these may be a good choice. However, not all tax-free bonds are completely tax-free, so make sure to verify whether those earnings are subject to state or local taxes.

Many funds offer products managed with the specific goal of tax-efficiency. These funds employ a buy-and-hold strategy and eschew dividend- or interest-paying securities. They come in a variety of forms, so it's important to consider risk tolerance and investment goals when looking at a tax-efficient fund.

Don't Focus on Short-Term Performance

There is money to be made in mutual funds, but investors fall into several pitfalls that keep them from maximizing their profits when investing in funds. Getting too focused on short-term results can be a big problem. As with individual securities, chasing performance can be a large negative when buying mutual funds.

For starters, there is little evidence to suggest that a mutual fund manager that performs well for a quarter, or even a couple quarters in a row, has investment skill. As Ben Graham also points out in The Intelligent Investor, short-term fluctuations are arguably random. The only surefire way to determine if a mutual fund manager has more investment skill than luck is to measure his or her performance through a full market cycle of three to five years. A manager with a few bad quarters, but a great long-term track record, could still end up being a great mutual fund to buy into.

After Thorough Due Diligence

A defensive investor doesn’t have the time or interest to find individual securities to buy. However, he or she must still spend considerable time finding the right mutual fund to buy, including researching the management team's performance track record, its reputation, how long the team has been together and an opinion on the reputation of the mutual fund company they work for.

There are many other metrics to study before deciding to invest in a mutual fund. Mutual fund rater Morningstar (Nasdaq:MORN) offers a great site to analyze funds and offers details on funds that include details on its asset allocation and mix between stocks, bonds, cash, and any alternative assets that may be held. It also popularized the investment style box that breaks a fund down between the market cap it focuses on (small, mid, and large cap) and investment style (value, growth, or blend, which is a mix of value and growth). Other key categories cover the following:

  • A fund’s expense ratios
  • An overview of its investment holdings
  • Biographical details of the management team
  • How strong its stewardship skills are
  • How long they have been around

For a fund to be a buy, it should have a mix of the following characteristics: a great long-term (not short-term) track record, charge a reasonably low fee compared to the peer group, invest with a consistent approach based off the style box and possess a management team that has been in place for a long time. Morningstar sums up all of these metrics in a star rating, which is a good place to start to get a feel for how strong a mutual fund has been. However, keep in mind that the rating is backward-focused. 

Index Funds

Jack Bogle founded Vanguard on the premise that most active mutual fund managers fail to add value for their mutual fund investors. This is largely true and has been covered at length in the financial press. It is due to a couple of key factors, one of which we identified above. Namely, many funds charge fees that are too high and eat into performance. Another key factor is whether a fund is a closet index fund. If it holds more than 100 stocks, it is highly likely that its performance will track its underlying index closely. If this is the case, it doesn't make sense to pay a higher fee for "active" management.

For this reason, index funds are another option to consider for defensive investors. They charge low fees and are designed to match a market index. Active managers lament that this strategy represents guaranteed underperformance, because the low fee must still be netted out of the index return, but it can still represent a strategy capable of beating active fund managers over the long haul.

When Are Mutual Funds the Wrong Choice?

In some situations, mutual funds may not be the best option for your client. Though mutual funds offer a degree of diversification most individual investors cannot match, they also require the investor give up control of her investment. This means mutual funds are not well suited for investors who want to play an active role in investment allocation and trading strategy. Mutual funds are managed by experienced professionals, which is generally considered one of their chief benefits. However, an investor who wants to know how and why each dollar is invested is better suited to a self-managed portfolio.

In addition, mutual funds may not be the best choice for clients who are primarily concerned with annual expenses. Unlike investing in individual stocks or bonds, mutual funds require shareholders to pay annual fees equal to a percentage of the value of their investments. This means any mutual fund needs to generate annual returns greater than its expense ratio in order for shareholders to profit.

High-yield funds require a very active management style, which can mean expense ratios of 2% to 3% to compensate for the fees generated by the frequent trading of assets. More passively managed portfolios may have much lower expense ratios, but this often corresponds to lower returns, as these funds are primarily oriented toward long-term growth rather than generating the highest yield.

Buying Mutual Funds

Of course, there are going to be times when a mutual fund is the main investment option available to investors. In this case, the decision isn’t whether to buy at all, but to pick the best fund of the bunch. Again, the starting point should be an index fund, with due diligence performed on any active fund options available.

Most retirement plans are going to offer only a mix of funds, though they are slowly starting to let investors self-direct into individual securities over time. The plans, including 401(k) for most corporations and 403(b) plans for non-profit organizations, are highly likely to only offer funds. Also, plan sponsors can’t provide investment advice, so you will have to go it alone and pick a mutual fund manager, based on the due diligence approach recommended above.

Active mutual funds sometimes get a bad rap as a group overall, but when combined with index funds they can represent a great way to get diversified exposure to just about any asset class. For instance, many international markets (especially the emerging ones) are just too difficult to invest in directly. A mutual fund can specialize in smaller markets and offer investment expertise that is worth paying an active fee for. Surprisingly, many European markets are not highly liquid or investor friendly. In this case, it pays to have a professional manager help wade through all of the complexities.

The Bottom Line

When it comes to buying a mutual fund, investors must do their homework. In some respects, this is easier than focusing on buying individual securities, but it does add some important other areas to research before buying. Overall, there are many reasons why investing in mutual funds makes sense and a little bit of due diligence can make all the difference – and provide a measure of comfort for investors.

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