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Are you thinking about investing in a mutual fund, but aren't sure how to go about it or which one is the most appropriate based on your needs? You're not alone. However, what you may not know is that the selection process is much easier than you think.

Identifying Goals and Risk Tolerance

Before acquiring shares in any fund, an investor must first identify his or her goals for the money being invested. Are long-term capital gains desired, or is current income preferred? Will the money be used to pay for college expenses, or to supplement a retirement that is decades away? Identifying a goal is an important step toward whittling down the list of the more than 8,000 mutual funds available to investors.

In addition, investors must also consider their risk tolerance. Can the investor accept dramatic swings in portfolio value? Or, is a more conservative investment more suitable? 

Finally, the investor's desired time horizon must be addressed. How long can the investor's money be tied up in the investment? Do they anticipate any liquidity concerns in the near future? Mutual funds have sales charges and that can take a big bite out of an investor's return over short periods of time. To mitigate the impact of these charges, an investment horizon of at least five years is ideal.

Style and Fund Type

If the investor plans to use the money for a longer-term need and can handle a fair amount of risk and volatility, a long-term capital appreciation fund may be a good choice.These funds typically hold a high percentage of their assets in common stocks and are, therefore, considered to be volatile in nature. They also carry the potential for a large reward over time.

Conversely, if the investor is in need of current income, an income fund may be a better choice. Government and corporate debt are two of the more common holdings in an income fund.

Of course, there are times when an investor has a longer-term need, but is unwilling or unable to assume substantial risk. In this case, a balanced fund, which invests in both stocks and bonds, may be the best alternative.

Charges and Fees

Mutual funds make their money by charging fees to the investor. It is important to understand the different types of fees associated with an investment before you make a purchase.

Some funds charge a sales fee known as a load, which will either be charged upon purchase or upon sale of the investment. A front-end load fee is paid out of the initial investment made by the investor, while a back-end load fee is charged when an investor sells the investment, usually if sold before a set time period, such as seven years from purchase. This is intended to deter investors from buying and selling too often. 

Both front- and back-end loaded funds typically charge 3% to 6% of the total amount invested or distributed, but this number can be as much as 8.5% by law. Its purpose is to discourage turnover and to cover any administrative charges associated with the investment. Depending on the mutual fund, the fees may go to a broker for selling the mutual fund or to the fund itself, which may result in lower administration fees later on.

No-load funds don't charge a front- or back-end load fee. However, the other fees in a no-load fund, such as the management expense ratio and other administration fees, may be very high.

Other funds charge 12b-1 fees, which are baked into the share price and are used by the fund for promotions, sales and other activities related to the distribution of fund shares. These fees come off of the reported share price at a predetermined point in time and as a result, investors may not be aware of the fee at all. The 12b-1 fees can be, by law, as much as 0.75% of a fund's average assets per year.

One final tip when perusing mutual fund sales literature: Always look at the management expense ratio. That one number can help clear up any and all confusion as it relates to sales charges. The ratio is simply the total percentage of fund assets that are being charged to cover fund expenses. The higher the ratio, the lower the investor's return will be at the end of the year.

Evaluating Portfolio Managers and Past Results

As with all investments, investors should research a fund's past results. To that end, the following is a list of questions that prospective investors should ask themselves when reviewing the historical record:

  • Did the fund manager deliver results that were consistent with general market returns?
  • Was the fund more volatile than the big indexes (meaning did its returns vary dramatically throughout the year)?
  • Was there an unusually high turnover (which can result in larger tax liabilities for the investor)?

This gives the investor insight into how the portfolio manager performs under certain conditions, as well as the fund's historical trend in terms of turnover and return.

Prior to buying into a fund, it makes sense to review the investment company's literature. In most cases, a candid fund manager will give the investor some sense of the prospects for the fund and/or its holdings in the year(s) ahead and discuss general industry and market trends that may affect the fund's performance.

Size of the Fund

Typically, the size of a fund does not hinder its ability to meet its investment objectives. However, there are times when a fund can get too big. A perfect example is Fidelity's Magellan Fund. Back in 1999 the fund topped $100 billion in assets and it was forced to change its investment process to accommodate the large daily (money) inflows. Instead of being nimble and buying small- and mid-cap stocks, it shifted its focus primarily towards larger capitalization growth stocks. As a result, its performance suffered.

So how big is too big? There are no benchmarks that are set in stone, but that $100 billion mark certainly makes it more difficult for a portfolio manager to efficiently run fund. 

History Often Doesn't Repeat

We’ve all heard that ubiquitous warning: “Past performance does not guarantee future results.” Yet looking at a menu of mutual funds in, say, your 401(k) plan, it’s hard to ignore the ones that have crushed the competition in recent years.

But are historical outcomes a good indicator of results down the road? The data would seem to indicate otherwise. One study looked at mutual-fund data over a 16-year period and found that just 7.8% of the top 100 fund managers in any given year retained that distinction the following year.

A separate report by Standard & Poor’s showed that only 21.2% of domestic stocks in the top quartile of performers in 2011 stayed there in 2012. And slightly more than 7% remained in the top quartile two years later.

Subsequent Performance of Mutual Funds in the Top Quartile in 2011


Source: Standard & Poor’s

Why are past results so unreliable? Shouldn’t star fund managers be able to replicate their performance year after year?

Certainly, some actively traded funds beat the competition fairly regularly over a long time period. But the inherent unpredictability of the market means that even the best minds in the business will have off years.

study by investment firm Robert W. Baird & Co. looked into this phenomenon. What the company found was that, even among fund managers who outpaced the market over a 10-year span, many experienced two- or three-year stretches where they trailed the pack.

Translation: When looking at a fund's recent outcomes and the numbers look unimpressive, it’s hard to tell if it’s a bad manager having a bad year or a good manager having a bad year.

There’s an even more fundamental reason not to chase high returns. If you buy a stock that’s outpacing the market – say, one that rose from $20 to $24 a share in the course of a year – it could be that it’s only worth $21. And once the market realizes the security is overbought, a correction is bound to take the price down again.

The same is true for a fund, which is simply a basket of stocks or bonds. If you buy right after an upswing, it’s very often the case that equilibrium is about to bring it back down.

What Really Matters

Rather than looking at what happened in the past, investors are better off taking into account the various factors that do influence future results. In this respect, it might help to learn a lesson from Morningstar, one of the country’s leading investment research firms.

Dating back to the 1980s, the company assigned a star rating to each fund based on risk-adjusted returns. However, research showed that these scores demonstrated little correlation with future success.

Morningstar has since introduced a new grading system based on five P’s: Process, Performance, People, Parent and Price. With the new rating system, it’s looking at the fund’s investment strategy, the longevity of its managers, its expense ratios and other relevant factors. The funds in each category earn a Gold, Silver, Bronze or Neutral rating.

The jury’s still out on whether this new method will fare any better than the original one. Regardless, it’s an acknowledgment that historical results, by themselves, tell only a small part of the story.

If there’s one factor that does consistently correlate with strong performance, it’s fees. This explains the popularity of index funds and ETFs, which, at a much lower cost than actively traded funds, mirror a market index.

It’s tempting to judge a mutual fund based on its recent returns. But if you really want to pick a winner, look at how well it’s poised for future success, not how it did in the past. For background, check out our Mutual Fund Basics Tutorial and 3 Strategies for Trading Mutual Funds.

The Bottom Line

Selecting a mutual fund may seem like a daunting task, but doing a little research and understanding your objectives and risk tolerance is half of the battle. If you follow this bit of due diligence before selecting a fund, you will increase your chances of success.

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