How to Pick the Right Mutual Funds

We recently covered the why and how of purchasing a mutual fund, but you were probably left wondering what exactly you should be looking for when choosing which funds to buy. It’s a great question and can often be a daunting one for a beginning investor. In reality, it’s relatively easy to research and find good mutual funds. Once you’ve done it a few times, you may actually begin to enjoy the thrill of the hunt!

The Longstanding Mutual Fund Debate

There are two camps when it comes to choosing mutual funds. The first consists of those who believe you should invest in actively managed mutual funds that outperform their peers and their indexes over time. The second camp consists of those who believe that the only type of mutual fund you should invest in are index funds. Index funds differ from actively managed funds in that they are typically managed passively by mathematical computation and computers.

Index fund fanatics, or Bogleheads (named after Vanguard and index fund founder John Bogle) as they are affectionately referred to, often cite the fact that the majority of actively managed funds are outperformed over time by their index fund counterparts, which cost less to own.

Regardless of which camp you favor, we will provide some general guidelines to follow when you are hunting for actively managed funds and how to compare them to their index fund counterparts.

How to Comparatively Measure a Mutual Funds Performance

1. Expense Ratio: Expenses are never good. They will eat into your returns over time. Be wary of a mutual fund with a high overall expense ratio, especially if its performance lags its index and peers over time. As a benchmark, there is no real reason to purchase a fund with more than a 1.2% overall annual expense ratio, and there are many good ones that can be found for less than a 1% expense ratio. Many index funds will have much lower fees than this, but fees should not be your only determining factor.

2. Fund Manager History: Here’s a dirty little secret of the mutual fund industry – the fund itself doesn’t really matter. It’s all about who is selecting the investments, not the ‘brand’ of the fund. When you buy an actively managed mutual fund, you are purchasing the skills of that fund’s particular manager. So, what should you look for in a fund manager?
Most important is sustained long-term performance success (at least 5 years) vs. the fund’s peers and index. Look also for loyalty to the fund that you are investing in. If they move, they take their skills with them. Lastly, you’ll want to find a fund manager with an investing philosophy that jives with your personal financial goals.

3. Load or No-Load: Funds with loads should not be purchased. Period. Loads are an additional management fee that claims a percentage of your overall investment when you move in or out of a fund (often-times around a whopping 4-6%). When there are numerous equally or better performing funds available that don’t carry a load, there is no reason compelling enough to pay the extra fee. Comparatively, index funds rarely have a load fee.

4. Net Assets: In the mutual fund world, it is possible to get too big. Some of the star mutual funds end up attracting performance chasing investors. This creates a problem in that the more money a fund has to invest, the less nimble it becomes. As a benchmark, stay away from actively managed funds that exceed $10 billion in net assets. When a fund exceeds this level, there is no real advantage to choosing it over its index fund counterpart. Many fund companies realize that this is an issue and they end up creating ’sister’ funds that mirror the strategy of the original fund, but with much less in the form of assets to slow them down.

5. Performance: If a managed fund is under-performing its peers and its comparable index fund, you’re probably better off going with their index fund and saving on the expenses. Look for long-term sustained success of at least 5 years, but preferably 10 or more.

Where do you Find all of this Information?

Most major investment aggregators will contain all five of the previously mentioned metrics and more. A few favorites to whittle down your possible fund selections are:
Morningstar’s mutual fund screener
Yahoo Finance fund screener

Once you have narrowed it down to a few funds, you’ll want to use tools such as those found at Morningstar and Google Finance to research each fund. You may also want to read the prospectus of the funds you are thinking of before making your final purchase.

For more of GE Miller’s writing, visit personal finance blog 20somethingfinance.com.