How To Pick The Right Mutual Fund

The finance market is ever-changing. It’s impossible to pick the winning or the best mutual funds. But follow some guidelines on funds selection, just as taking a careful look at a variety of positive fund characteristics - the quality of the fund company, style consistency, long-term management tenure, low expenses, low portfolio turnover and appropriate asset size, we are capable to make an informed selection of a managed mutual fund based on our needs.

Identifying Goals and Risk Tolerance
Before acquiring shares in any fund, an investor must first identify his or her goals and desires for the money being invested. Are long-term capital gains desired, or is a 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 important because it will enable you to dramatically whittle down the list of the more than 8,000 mutual funds in the public domain.

In addition, investors must also consider the issue of risk tolerance. Is the investor able to afford and mentally accept dramatic swings in portfolio value? Or, is a more conservative investment warranted? Identifying risk tolerance is as important as identifying a goal. After all, what good is an investment if the investor has trouble sleeping at night?

Finally, the issue of time horizon must be addressed. Investors must think about how long they can afford to tie up their money, or if they anticipate any liquidity concerns in the near future. This is because mutual funds have sales charges, that can take a big bite out of an investor's return over short periods of time. Ideally, mutual fund holders should have an investment horizon with at least five years or more.

Style and Fund Type
If the investor intends to use the money in the fund for a longer term need and is willing to assume a fair amount of risk and volatility, then the style/objective he or she may be suited for is a long-term capital appreciation fund. These types of 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, he or she should acquire shares in an income fund. Government and corporate debt are the 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 gain an understanding of the different types of fees that you may face when purchasing an investment.

Some funds charge a sales fee known as a load fee, which will either be charged upon initial investment 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 his or her investment, usually prior to a set time period, such as seven years from purchase.

Both front- and back-end loaded funds typically charge 3-6% 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.

To avoid these sales fees, look for no-load funds, which don't charge a front- or back-end load/fee. However, be aware of the other fees in a no-load fund, such as the management expense ratio and other administration fees, as they may be very high.

Still 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 right off of the reported share price at a predetermined point in time. As a result, investors may not be aware of the fee at all. 12b-1 fees can, by law, be as much as 0.75% of a fund's average assets per year.

One final tip when perusing mutual fund sales literature: The investor should look for the management expense ratio. In fact, 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 Managers/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 perspective 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 information is important because it will give the investor insight into how the portfolio manager performs under certain conditions, as well as what historically has been the trend in terms of turnover and return.

With that in mind, past performance is no guarantee of future results. For this reason, prior to buying into a fund, it makes sense to review the investment company's literature to look for information about anticipated trends in the market in the years ahead. 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 as well as discuss general industry trends which may be helpful.

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 for the first time, 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 toward larger capitalization growth stocks. As a result, its performance has suffered.

So how big is too big? There are no benchmarks that are set in stone, but that $100 billion mark certainly makes it difficult for a fund manager to acquire a position in a stock and dispose of it without running up the stock dramatically on the way up, and depressing it on the way down. It also makes the process of buying and selling stocks with any kind of anonymity almost impossible.

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

What’s on Your mutual fund shopping list

For most investors, beating the market is the holy grail of investing. So few people manage to do it that those who do are elevated to the status of legends by the investment community. How else could you explain the popularity of such stock-picking wizards as Warren Buffett, Peter Lynch, Bill Miller, and Marty Whitman? Those who manage to accomplish this difficult feat are generously rewarded over time.

Yes, each and every year there are some mutual funds that beat the overall market, and there are even years when the majority of mutual funds beat the market. But trying to pick a mutual fund ahead of time that will beat the market is extraordinarily difficult. When "mutual fund experts" are asked to pick mutual funds that they think will beat the market, they almost always fail, typically with disastrous results. In 1998, ten mutual fund experts were asked by USA Today to pick two mutual funds for the year. None, none, were able to pick a fund that beat the market. Studies show that picking mutual funds on the basis of past performance does not work, and saints preserve anyone who picks mutual funds on the basis of screaming magazine headlines.

So, can we imagine a time when one would willingly choose to put his hard-earned money into a mutual fund?

Imagine one walking down the street, innocently minding his own business, thinking only of ways to educate, amuse, or otherwise enrich some of his fellow men. Imagine that the one, lost in his thoughts, doesn't notice that the street he is on is Wall Street, and that suddenly he is cornered by an extremely well-dressed gun-toting thug who starts screaming, "We measure success one actively managed mutual fund sold at a time! Pick one now, or I'll blow your head off!"

Seem improbable? It should. It really should. We know Wall Street is full of a lot of irrational people, but we really don't think any of them would do this. We hope not anyway. Time will tell.

But, in reality, many people are confronted with the necessity of picking mutual funds from of a selection in their 401(k) plans when an index fund is not one of the options. If you remember what we have described so far in the previous sections, you'll have no problem going about picking a fund. If you skipped some of those articles, fell asleep, got distracted by the television, have short-term memory problems, or just can't get enough reviews of things you've already read once, here are the salient points set forth again.

Your mutual fund shopping list should read:

1. No sales charges (front loads, contingent deferred sales loads, level loads)
2. A low expense ratio (below 1.00%)
3. Low turnover, no higher than 50% a year, and preferably closer to 20%
4. Full investment policy. Cash reserves of nearly 0%.

Studies show that over time, virtually all of the difference in return between managed funds and index funds is attributable to the higher costs imposed by actively managed funds. These costs come in the form of loads and expense ratios.

You want to make sure that you are not paying any sales charges. Sales charges come in various stripes, also known as loads or commissions. There might be a charge for buying into the fund (a front-end load) or selling the fund (back-end load, deferred sales charge, or redemption fee). Avoid all of these. Some funds have back-end loads that are reduced the longer you hold the fund. Best to avoid these as well. If you have to buy an actively managed fund, buy the fund with no sales charges at all. Funds that normally have sales charges sometimes waive them or have reduced sales charges for large 401(k) accounts.

Expense ratios represent the annual fees charged by all funds, including the management fee, the administrative costs, 12b-1 distribution fees, and other operating expenses. You want to make sure that the fees are as low as possible. Index funds typically charge about 0.20% of the assets, and actively managed funds currently average about 1.5% per year. The average fee, by the way, has actually been climbing in recent years. Any fund that has fees above 1% per year can be expected to underperform the total returns offered by an index fund.

Turnover measures how long a fund holds on to the stocks it buys. The longer a mutual fund holds on to a stock and the less trading the fund does, the lower the turnover will be. Since a fund incurs costs every time it buys and sells stocks (just like you do), the lower the turnover, the lower the transaction costs incurred by the fund -- and the lower the capital gains taxes. Ideally, Fools like to see funds that practice the "buy and hold" method of investing -- those funds are the most index-like. Funds that have a turnover of 100% are essentially buying a completely new set of companies every year. Turnover should ideally be substantially lower than the mutual fund average of about 80%. Index funds have turnover as low as 5%.

A mutual fund that has an established track record is less important than you would think. Studies show that measuring performance over two decades or longer, 99% of funds that outperform the market in one decade revert to the mean in the next decade. Past performance really isn’t an indication of future results. If a fund has outperformed the S&P 500 recently, determine how it does against similar Morningstar style box funds.

Make sure to check out the consistency of the fund's returns. You are looking for funds that not only have shown good returns on the whole, but ones that do so on a consistent basis, rather than having great runs followed by lousy ones. Most funds that claim to have outperformed the market over a ten-year period really had most or all of their truly good performance when they were young and small. Once the fund has attracted a couple of billion extra dollars, the fund usually starts performing more in line with the market.

Keep the fees low and select from low turnover funds and you'll generally outperform most mutual funds. An even briefer summary would be, "Just buy an index fund."