With more than 28,000 mutual funds available, it can be an overwhelming task to pick just a few to invest in. There are not only many to consider but also three different types to pull from.
Below are some considerations that will help you narrow down your choices. (For more insight, read our complete guide to mutual funds.)
Know Your Goal
Knowing what you are saving and when you're going to need to spend the money can help you narrow down your choices in mutual funds.
For example, if you are saving for your kids' college and they are leaving in three years, you can determine what asset allocation you need. Then you can select from funds that fit that allocation.
If, on the other hand, you are saving for retirement and are thirty years away from stopping work, you can base your decision on suggested asset allocations that allow you to focus on finding equity funds.
Account Type Factor
The tax status of the account that you are planning on investing in can have a big impact on what you look for in funds. If you are using taxable accounts, you will want to minimize any capital gains you get in order to keep the impact of taxes low. However, if you are looking into a tax-protected account such as an IRA, you have less of a concern for any significant capital gains.
If you are saving in a taxable account, you will want to look for a fund with a low turnover ratio and a good tax adjust return. If you are using a tax-friendly account, you can look at some more active fund managers without taking a major tax hit every time there is a sale of a stock. (For related insight, read about whether mutual funds pay dividends or interest.)
Active Versus Passive Funds
Active funds involve a fund manager who attempts to beat the market with various investing strategies and the buying and selling of one's securities. Deciding that you would rather have a passive fund – one that merely mirrors a market index – immediately cuts down the number you have to sort through to about 1,200 funds.
The Fees Factor
Management fees can be the biggest killer of returns. Because they have such a big impact on what you end up making in your investment, you want to make sure that your fund is not charging extremely high fees.
If you are searching for actively-managed funds, a great target should be below the 1.0% fee level. If you are investing in passive funds, you can usually find fees as low as 0.1%.
Looking for Consistent Performance
You are not looking for the best mutual fund of the year – one that might be a one-hit wonder. Instead, you are looking for a fund that consistently beats its category and the index it is compared to. You want to be able to stay in your fund for the long term, so you need one that has shown it can produce consistent returns compared to the other funds in the category.
The exception here is if you are investing in index funds. With these, you just need to make sure they are getting a return that is right around the index’s performance. (For more insight, read about how to analyze mutual fund risk.)
Looking at each of these metrics, you could narrow in on your fund as follows. Say you're saving for retirement in a taxable account and you want to have passive funds. You would then search for index funds with an expense ratio below 0.25% and a low tracking error.
Another example would be saving for your kid's college tuition. He is leaving in three years. You want to use active management. Based on asset allocation, you would want to look for bond funds with low fees and good performance.
The Bottom Line
There are many options to choose from when picking mutual funds. The more you know about your goals, what accounts you are using and if you prefer active or passive, you'll be able to better search via some basic criteria such as fees and performance. (For related insight, read about the 4 best total market index funds.)