Investing 101: Selecting Mutual Funds

Editor’s note: Mutual funds are a staple of most investors’ portfolios, yet young investors often put their money in a mutual fund without fully understanding how it works. We’ll walk you through the basics in the fourth installment of MintLife’s Investing 101 series, provided by Minyanville.com.

Many first-time investors start out buying shares of mutual funds. They rely on professional management to select a portfolio of stocks based on whether they seek income or growth.

However, most investors tend to pick which fund or funds to invest in by looking at past performance — and that isn’t necessarily the best way to make an investment decision.

Past performance often is limited to the best time span to report performance. For example, if a fund has reported a 250% growth rate over three years, but a 15% net loss over five years, it is crucial to know the full picture to get a better understanding of its performance.

Funds collect investment dollars from thousands of people and select a portfolio designed to maximize market performance. The disturbing reality is, though, that most funds perform below the broader market. As Jeremy Siegel writes in Stocks for the Long Run, between 1986 and 2000, the largest blue chip equity funds reported growth at or below 250%. In comparison, the S&P 500 reported 600%.

In the more dismal years of 2005 to 2008, the big funds lost over 40% of value, while the S&P fell by 30%.

So given this record, how do you pick a mutual fund? Rather than looking to the past, consider the size of assets held by a fund. Larger is not better. A smaller, growing mutual fund has more flexibility to move in and out of positions and may out-perform a larger competitor. Also be sure the fund you pick is a good match for your investment goals and risk tolerance.

Beginners might want to use a financial planner, but paying a sales commission (called a load in mutual fund parlance) also does not guarantee better performance. After all, if an adviser charges you a 5% front load, the mutual fund you buy would have to perform that much better in order for you to merely make up for that lost commission.

An array of different fees and expenses make performance comparisons very difficult. The Financial Industry Regulatory Authority (FINRA) provides a free mutual fund calculator, which allows you to compare the fees charged by funds and to determine which one will work best for you.

Also be aware of the kind of fund involved. The traditional open-end fund accepts investments without limit, but a closed-end fund limits the total dollar amount it will accept. An exchange-traded fund (ETF) typically identifies a “basket of securities” in advance by tracking a certain stock or bond index, rather than using a management team to handle a portfolio. ETFs have become very popular in recent years and dozens exist for specific industries, currencies, commodities, and even stocks of companies in specified countries or regions.

Selecting the best mutual fund is no simple matter. In some respects, it is even more complicated than picking a company and its stock. A company can be judged based on its competitive stance in an industry and the product or service it sells. A mutual fund is simply a collection of investment dollars placed under management or tracking an index.

Mutual funds deserve to be seriously considered in a person’s portfolio, especially if they are not sure how to select stocks to buy directly. But a good degree of initial research is a smart way to narrow the field and to better understand exactly how the fund works and what benefits it offers.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes fulltime.

Investing 101: How to Select a Mutual Fund was provided by Minyanville.com.