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.

Valerie Everett

The simple answer to the question ‘why should I buy a mutual fund?’ recalls the proverbial joke about the chicken crossing the road. The answer, ‘to get a good return on my investment’, or even more simply ‘to make money’ seems so obvious as to be almost an insult to one’s intelligence. But mutual funds are just one of a variety of potential investment vehicles. Stocks, bonds, and other investments that are available for purchase also offer the potential to make money. So what makes mutual funds the investment of choice for many? When you boil it down, mutual funds provide three major benefits for those who decide to invest in them:

1. Diversification, 2. Expertise, .. and 3. Time

What do each of these mean?

Diversification: In times of high volatility and risk, owning one, two, or even five different stocks, bonds, or whatever security you’d like to invest in can be risky in that there is simply no guarantee that your picks are going to be winners. Mutual funds, on the other hand, offer risk diversification. This means that funds purchase more than a few different investments and the risk of losing significantly in any one investment is minimized by being distributed over a number of investments.

Expertise: You can be fairly certain that professional mutual fund managers have more research, knowledge, connections, and experiences at their disposal than you do. However, expertise and resources don’t always produce stellar results. In fact, only 31% of actively managed stock-based mutual funds outperformed the S&P 500 over the five years ending Dec. 31, 2008. That’s why many investors choose index mutual funds as an alternative to actively managed funds. Index funds simply aim to match the performance of the index that they are following. Since index funds don’t have professionals choosing the investments, their fees tend to be lower than actively managed funds. Whether you choose index or actively managed funds, you are paying for the expertise and convenience offered by those funds.

Time: Without professional resources at your disposal, successful investing can take an extreme amount of time and energy. There is a very high learning curve involved in investing that few have enough time to pick up. If you opt to buy more investments in order to diversify, your time commitment only increases. Opting to put your money into mutual funds frees the time that it takes to research and keep up with each of your individual investments.

How to Purchase a Mutual Fund

If you’ve determined that you want to purchase a mutual fund, here’s how you can do it, step-by-step.

1. Choose a discount brokerage (i.e. Zecco, Scottrade, Etrade, Fidelity, Schwaab, etc.) to purchase your fund through. You could opt to invest in mutual funds through a full service advisor, but there is a wealth of comparative resources available to help you choose your fund for free so that you can purchase through a low fee discount broker instead.

2. Start an investment account through your broker. This could be a a general trading account or a retirement account such as a Roth IRA or Traditional IRA.

3. Research. In an upcoming post, we’ll highlight what you should look for in a mutual fund. For starters, you may want to focus on choosing a fund that consistently has at least met and preferably beat the performance of its peers at a fee that is lower than its peers.

4. Fund your Account: You must send in money via check, wire, or other deposit to your discount broker. Once your account has funds available, you can make your mutual fund purchase.

5. Make your Purchase. Enter a dollar amount that you’d like to apply towards the fund. This differs from entering a price you want to pay as you do when you purchase a stock. The price you will pay for each share will be the closing price on the day that you purchase the fund. The amount you enter will be divided by that share price to determine how many shares of the fund you will receive. When you first purchase a fund, you need to indicate whether you would like your dividends, capital gains, or both reinvested into additional shares. You can change this election at a later time. There is little reason not to choose ‘both’.

Some funds offer no transaction fees when you make a purchase. For those that do charge a fee (typically $25-50) you do not have to pay this fee when you purchase additional shares of the same fund. It’s also worth noting that many funds require a minimum initial purchase that depends on what type of investment account you are using.

6. Add to your Shares Over Time at your Discretion

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