A mutual fund is a type of investment product where the funds of many investors are pooled into an investment product. The fund then focuses on the use of those assets on investing in a group of assets to reach the fund's investment goals. There are many different types of mutual funds available. For some investors, this vast universe of available products may seem overwhelming.

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How To Pick A Good Mutual Fund

Identifying Goals and Risk Tolerance

Before investing in any fund, you must first identify your goals for the investment. Is your objective long-term capital gains, or is current income more important? Will the money be used to pay for college expenses, or to fund a retirement that's decades away? Identifying a goal is an essential step in whittling down the universe of more than 8,000 mutual funds available to investors.

You should also consider personal risk tolerance. Can you accept dramatic swings in portfolio value? Or, is a more conservative investment more suitable? Risk and return are directly proportional, so you must balance your desire for returns against your ability to tolerate risk.

Finally, the desired time horizon must be addressed. How long would you like to hold the investment? Do you anticipate any liquidity concerns in the near future? Mutual funds have sales charges, and that can take a big bite out of your return in the short run. To mitigate the impact of these charges, an investment horizon of at least five years is ideal.

KEY TAKEAWAYS

  • Before investing in any fund, you must first identify your goals for the investment.
  • A prospective mutual fund investor must also consider personal risk tolerance.
  • A potential investor must decide how long to hold the mutual fund.
  • There are several major alternatives to investing in mutual funds, including exchange-traded funds (ETFs).

Style and Fund Type

The primary goal for growth funds is capital appreciation. If you plan to invest to meet a long-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 risky in nature. Given the higher level of risk, they offer the potential for greater returns over time. The time frame for holding this type of mutual fund should be five years or more.

Growth and capital appreciation funds generally do not pay any dividends. If you need current income from your portfolio, then an income fund may be a better choice. These funds usually buy bonds and other debt instruments that pay interest regularly. Government bonds and corporate debt are two of the more common holdings in an income fund. Bond funds often narrow their scope in terms of the category of bonds they hold. Funds may also differentiate themselves by time horizons, such as short, medium, or long term.

These funds often have significantly less volatility, depending on the type of bonds in the portfolio. Bond funds often have a low or negative correlation with the stock market. You can, therefore, use them to diversify the holdings in your stock portfolio.

However, bond funds carry risk despite their lower volatility. These include:

  • Interest rate risk is the sensitivity of bond prices to changes in interest rates. When interest rates go up, bond prices go down.
  • Credit risk is the possibility that an issuer could have its credit rating lowered. This risk adversely impacts the price of the bonds.
  • Default risk is the possibility that the bond issuer defaults on its debt obligations.
  • Prepayment risk is the risk of the bondholder paying off the bond principal early to take advantage of reissuing its debt at a lower interest rate. Investors are likely to be unable to reinvest and receive the same interest rate.

However, you may want to include bond funds for at least a portion of your portfolio for diversification purposes, even with these risks.

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

Fees and Loads

Mutual fund companies make money by charging fees to the investor. It is essential to understand the different types of charges associated with an investment before you make a purchase.

Some funds charge a sales fee known as a load. It will either be charged at the time of purchase or upon the sale of the investment. A front-end load fee is paid out of the initial investment when you buy shares in the fund, while a back-end load fee is charged when you sell your shares in the fund. The back-end load typically applies if the shares are sold before a set time, usually five to ten years from purchase. This charge is intended to deter investors from buying and selling too often. The fee is the highest for the first year you hold the shares, then dwindles the longer you keep them.

Front-end loaded shares are identified as Class A shares, while back-end loaded shares are called Class B shares.

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

There is also a third type of fee, called a level-load fee. The level load is an annual charge amount deducted from assets in the fund. Class C shares carry this sort of charge.

No-load funds do not charge a load fee. However, the other charges in a no-load fund, such as the management expense ratio, 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 the reported share price at a predetermined point in time. 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 annual assets under management. 

It's necessary to look at the management expense ratio, which can help clear up any confusion relating to sales charges.

The expense 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. 

Passive vs. Active Management

Determine if you want an actively or passively managed mutual fund. Actively managed funds have portfolio managers who make decisions regarding which securities and assets to include in the fund. Managers do a great deal of research on assets and consider sectors, company fundamentals, economic trends, and macroeconomic factors when making investment decisions.

Active funds seek to outperform a benchmark index, depending on the type of fund. Fees are often higher for active funds. Expense ratios can vary from 0.6% to 1.5%.

Passively managed funds, often called index funds, seek to track and duplicate the performance of a benchmark index. The fees are generally lower than they are for actively managed funds, with some expense ratios as low as 0.15%. Passive funds do not trade their assets very often unless the composition of the benchmark index changes.

This low turnover results in lower costs for the fund. Passively managed funds may also have thousands of holdings, resulting in a very well-diversified fund. Since passively managed funds do not trade as much as active funds, they are not creating as much taxable income. That can be a crucial consideration for non-tax-advantaged accounts.

There's an ongoing debate about whether actively managed funds are worth the higher fees they charge. The S&P Indices Versus Active (SPIVA) report for 2017 was released in March 2018, and it showed some interesting results. Over the past five years and the past 15 years, no more than 16% of managers in any category of actively managed U.S. mutual funds beat their respective benchmarks. Of course, most index funds don't do better than the index, either. Their expenses, low as they are, typically keep an index fund's return slightly below the performance of the index itself. Nevertheless, the failure of actively managed funds to beat their indexes has made index funds immensely popular with investors of late.

Evaluating Managers and Past Results

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

  • Did the fund manager deliver results that were consistent with general market returns?
  • Was the fund more volatile than the major indexes?
  • Was there unusually high turnover that might impose costs and tax liabilities on investors?

The answers to these questions will give you insight into how the portfolio manager performs under certain conditions, and illustrate the fund's historical trend in terms of turnover and return.

Before buying into a fund, it makes sense to review the investment literature. The fund's prospectus should give you some idea of the prospects for the fund and its holdings in the years ahead. There should also be a discussion of the 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. In 1999, the fund topped $100 billion in assets and was forced to change its investment process to accommodate the large daily investment inflows. Instead of being nimble and buying small and mid-cap stocks, the fund shifted its focus primarily toward large growth stocks. As a result, performance suffered.

So how big is too big? There are no benchmarks set in stone, but $100 billion in assets under management certainly makes it more difficult for a portfolio manager to efficiently run a 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 for your 401(k) plan, it’s hard to ignore those that have crushed the competition in recent years.

A report by Standard & Poor’s showed that just 21.2% of domestic stocks in the top quartile of performers in 2011 stayed there in 2012. Furthermore, only about 7% remained in the top quartile two years later.

Subsequent Performance of Mutual Funds in the Top Quartile in 2011

Mutual fund performance in 2011, 2013, and 2013

Source: Standard & Poor’s

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

Some actively managed funds beat the competition fairly regularly over a long period, but even the best minds in the business will have bad years.

A study by investment firm Robert W. Baird & Co. looked into this phenomenon. The company found that even successful fund managers experienced periods of underperformance lasting two or three years.

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. 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 the pendulum will swing in the opposite direction.

Selecting What Really Matters

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

Since the 1980s, the company has assigned a star rating to mutual funds 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, the company looks at the fund’s investment strategy, the longevity of its managers, 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 perform 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 is one factor that consistently correlates with strong performance, it is fees. Low fees explain the popularity of index funds, which mirror market indexes at a much lower cost than actively managed funds.

It’s tempting to judge a mutual fund based on recent returns. 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.

Alternatives to Mutual Funds

There are several major alternatives to investing in mutual funds, including exchange-traded funds (ETFs). ETFs usually have lower expense ratios than mutual funds, sometimes as low as 0.02%. ETFs do not have load fees, but investors must be careful of the bid-ask spread. ETFs also give investors easier access to leverage than mutual funds. Leveraged ETFs are far more likely to outperform an index than a mutual fund manager, but they also increase risk.

The race to zero-fee stock trading in late 2019 made owning many individual stocks a practical option. It is now possible for more investors to buy all the components of an index. By buying shares directly, investors take their expense ratio to zero. This strategy was only available to wealthy investors before zero-fee stock trading became common.

Publicly traded companies that specialize in investing are another alternative to mutual funds. The most successful of these firms is Berkshire Hathaway, which was built up by Warren Buffett. Companies like Berkshire also face fewer restrictions than mutual fund managers.

The Bottom Line

Selecting a mutual fund may seem like a daunting task, but doing a little research and understanding your objectives makes it easier. If you carry out this due diligence before selecting a fund, you'll increase your chances of success.