Finding the right mutual fund might seem like a never ending maze of possibilities. But it doesn’t have to be complicated. Here are some simple guidelines to help you choose a mutual fund that fits perfectly with your portfolio.
Before we begin, you should have a diversified asset allocation strategy in place. From there you can pick mutual funds that meet each part of your strategy.
Choosing A Mutual Fund
I’d be willing to bet that many people start their mutual fund search looking at performance, ratings, or some type of best funds list. Rather, you should start your search with the mutual fund’s holdings and compare similar funds from there.
If you want an allocation of 40% U.S. stocks, 20% international stocks, 20% U.S. government bonds, and 20% U.S. corporate bonds, make sure the funds you choose invest in those areas. There’s no point owning any fund if the holdings don’t match up with your allocation strategy. It just increases your overall risk if you do.
For index funds and some mutual funds this is easy. The fund name almost always describes the fund’s objectives. Thanks to SEC rules, if a fund is called ABC Stock Fund, 80% of the fund must be invested in the assets described in the name. In this case, 80% must be invested in stocks. You’re not off the hook entirely, you should find out where the other 20% is invested and the fund’s prospectus has all that information.
This becomes more important when the fund name leaves you guessing. Or when a mutual fund’s objectives aren’t very black and white. In other words, the fund manager has a lot a discretion where the fund invests money. One year the fund could be mostly invested in bonds. The next year, its heavily invested in stocks. Big changes like that, affect your allocation and add risk to your portfolio. You don’t want to be hit by any surprises after the fact.
This where a site like Morningstar is really helpful. Punch in the fund name or ticker and the Portfolio tab will give you all the fund’s holdings. You can also find the most recent fund prospectus under the Filings tab.
Once you’ve found a few worthy funds that match your allocation needs, its time to start comparing costs.
Every dollar you’re spending in fees, is one less dollar you could be investing. Once you’ve paired your choices down to two or three funds, fees start to matter. You’ll need to check for sales fees, expense ratio, and turnover ratio.
There are several types of funds to watch out for:
- Load funds – have a high sales fee charged (anywhere from 3% – 8%) on either the front-end or back-end that acts as a commission paid to a broker
- No Load funds – have no sales fee or commission
If you have the choice between the two, no load funds are the way to go. But the costs don’t end there. Both types of funds still have an expense ratio and turnover ratio to consider.
The expense ratio is an annual fee charged by all funds. It covers the annual expenses of running a fund. A lower expense ratio is better when keeping costs down.
The same is mostly true for the turnover ratio, which measures the percentage of the fund’s assets that have changed in a year. When a fund sells a stock to buy another, that’s known as turnover. There’s a cost every time it happens. A lower turnover ratio is generally better. Index funds in particular have the lowest turnover ratios around.
Combine it all together and all three costs impact a fund’s performance.
We’ve seen and heard the warning label on every fund. Past performance doesn’t guarantee future results. Yet, performance is usually the first place we look when choosing a mutual fund. Sadly, it’s probably the least important.
What you don’t want to do is pick a fund based on last years performance. What’s worse is picking a new fund every year based on the prior years performance. This is better known as chasing returns. Instead you should pick a fund whose holdings match your allocation objectives, has low fees, and stick with it.
Where performance does help, is with comparing similar funds. If you’ve gotten this far and still have a couple of funds that fit your needs and the costs are similar, compare performance over the past three, five, and ten years. If it’s an index fund compare it to its benchmark. It might not seem like much, but a 1% difference in the annual return adds up to tens of thousands of dollars over twenty or thirty years.
To wrap it up, when you choose a mutual fund, first make sure the fund fits your asset allocation strategy. Don’t waste time on mutual funds that don’t work for you. Second, fees matter. Low cost funds outperform high costs funds and that means more money for you. Finally, if one fund still doesn’t stand out, compare performance over multiple time periods.