How to Choose a Mutual Fund

You know that mutual funds are great long-term investments, but you may be stumped by the thousands of available options. Fortunately, learning how to choose the right mutual fund for you isn’t as hard as it may seem. Once you understand the basics of mutual funds, you’re ready to do some fund research and finally buy. This article helps you navigate the selection process and learn how to choose a mutual fund with three steps: 

• Define what you’re looking for in a fund
• Look for funds that maximize your investment
• Use a fund screener

Define what you’re looking for in a fund

Your financial goals and the amount of risk you’re willing to assume determine which type of fund you should buy. Think about the following considerations when choosing funds: 

• Consider the time you want to spend managing your investments – If you love reading about financial trends and managing your own investments, consider funds that you need to frequently research and monitor. Active funds that are fairly volatile are good choices for an investor that fits this description. Go with index funds or low risk money market funds if you prefer to be hands off.  
• Decide how much money you want to invest – Many funds have minimum contribution requirements the first time you buy shares. Minimum contributions usually start around $1,000 but can be as high as $25,000. Choose a mutual fund with a low minimum requirement if your initial investment is modest. Consider purchasing mutual fund shares within an Individual Retirement Account (IRA), which sometimes have lower minimum investment requirements.
• Know how often you’ll invest in the fund – Some investors make occasional contributions to their mutual funds while others opt for monthly or quarterly contributions. Choose a fund without a transaction fee if you’re going to make frequent contributions. Transaction fees can be as low a few dollars per contribution, but they add up if you contribute money several times a year.
• Think about when you want to withdraw your money – Consider a mutual fund dedicated to retirement plans if you don’t plan to withdraw money from the fund before retirement. American Century Livestrong and Fidelity Freedom are examples of retirement funds that invest in aggressive funds during your early and middle adulthood and switch to more conservative investments as you near retirement age. As a 20 or 30 something investor, you should choose funds with a target retirement date of 2035 or 2040. 
• Decide how much risk you can assume – Select active funds with a strong record of growth if you’re open to a lot of risk and hope for a big payout. Choose index funds if you want the safest investment possible. Keep in mind, though, that mutual funds are never risk-free.
• Know what the mutual fund invests in – Mutual funds typically invest in one of three types of investments – stocks, bonds, or money markets. A stock fund invests its pool of money in stocks, which are also known as equities. Active stock funds can be fairly risky because individual stocks are often very volatile. In contrast to risky stock funds, money market funds are required by law to have low-risk investments and are a fairly safe choice. Bond funds – as the name implies – are funds in which all investments are made in bonds. Many people think bonds are always low-risk, but bond funds can be risky choices if the manager maintains a high portfolio turnover rate. Some funds invest in a combination of stocks, bonds, and money markets, which can be a great way to spread your risk across different types of investments through the purchase of one fund. Check out American Century Livestrong funds  – a popular choice that invest in all three.

Look for funds that maximize your investment

Good mutual funds share certain characteristics. Most importantly, they’re low cost and have strong long-term performance. To maximize your investment, look for funds that meet these criteria:

• Low expense ratios – The expense ratio is the percent of the fund’s assets used to pay operational expenses, and varies largely between funds. Many active funds have expense ratios close to two percent, but index funds have much lower and more attractive expense ratios. Look for expense ratios below 0.5 percent. Many index funds, like the Fidelity Spartan Total Market Index Fund (FSTMX), have expense ratios as low as 0.1 percent. If you invest $10,000 in a fund with a two percent expense ratio, $200 of your money will help pay managers’ salaries and other expenses each year. The same $10,000 investment in a fund with a 0.1 percent expense ratio costs only $10 annually. Higher expense ratios will cost you thousands of dollars over the life of your investment. 
• No-Load – A fund with a load will cost you more money than one without a load. A front-end load fund charges you a percentage of your total investment when you purchase shares. With back-end load funds, you pay a fee if you sell your shares within one year. If you invest $10,000 in a fund with a five percent front-end load, you’ll pay $500 just for the privilege of owning shares in the fund. Why bother when hundreds of funds are no-load? A fund with a load does not necessarily perform better than a no-load mutual fund and is never a good choice. You can use a mutual fund investment calculator to help you estimate your expenses. Financial Industry Regulatory Authority's (FINRA) calculator is free and lets you compare expenses of up to three funds at once.
• Low portfolio turnover rate – The portfolio turnover rate is the rate at which the fund acquires and unloads assets. Funds with a high portfolio turnover rate tend to have higher expenses and are more volatile than funds with low turnover rates. You also may have to pay taxes on capital gains if you invest in a mutual fund with a high turnover. Look for a portfolio turnover rate that’s below 30 percent; many index funds have portfolio turnover rates in the single digits. 
• Strong past performance – When you compare funds in a screener, you’ll see graphs and tables that show their performance over three, five, or ten years. Unless you seek extremely high-risk investments, look for funds that aren’t that volatile. You’re typically better off with a fund that produces slow and steady gains over five or ten years rather than one that has phenomenal returns for one or two years.  
• Long manager tenure – The length of time that a manager has been with a particular fund doesn’t always correlate with a fund’s performance, but active funds that have been managed by the same person for several years tend to perform better in the long run. After all, when managers manage a fund poorly, they usually get fired!

Use a fund screener

Once you know what type of fund you’re looking for, it’s time to do some mutual fund research. Use a mutual fund screener to help you narrow down the thousands of available mutual funds based on your individual criteria. A fund screener lets you specify the type of fund, whether or not there is a load, and the expense ratio. There are several free fund screeners – try out Morningstar's fund analyzer. You can also use fund screeners from the Wall Street Journal or Forbes. It’s a good idea to input the same criteria in two or three screeners because results will differ depending on the screener’s algorithms.   

Click on funds within the fund screener results that look promising. You’ll find important information, including the funds’ expense ratios and historical performance. Many screeners let you select three to five funds at once so you can compare choices easily. Take notes about each of the funds that the screeners suggest, paying attention to your specified criteria. Then, look at the results in aggregate and select the best funds for you.

Many sites have their own system for rating mutual funds that can make finding a high-performing mutual fund a little easier. For example, Morningstar uses a five-star rating system and ranks funds according to their performance compared to similar funds. Use the screener ratings as a guide but consider other criteria as well; a fund may have a low rating simply because its manager chooses less risky – and less lucrative – investments.

Investing in mutual funds is never a risk-free endeavor. As the economy swings up and down, your investment will increase and decrease in value. However, a good mutual fund will increase over the long-term and have minimal costs. Choose one or two solid funds and make regular monthly or quarterly contributions. If you begin saving consistently now, you’ll be in good financial shape when you’re ready to retire.

By: Jessica Bayliss

7-23-2009

Jessica Bayliss is a freelance writer specializing in finance and education. She has degrees from the University of Illinois and Texas A&M-Kingsville and is still learning all about what college forgot.

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