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Investment Planning |
How to Choose a Mutual Fund
Deciding which mutual fund to buy is based on many factors, including your long term goals and the other assets in your investment portfolio. Let's say you know that you won't need the funds for at least five to seven years (therefore we are discussing money that you won't need in the short term) and you've identified an asset class to invest in. Now you can look at quantitative and qualitative factors.
The quantitative factors to consider relate to the fund's performance. You can look at the Morningstar star rating, but this shows only a small piece of the picture. Also look at the Morningstar category rating, which shows how well this fund did compared to its category peers. Look at the expense ratios of the fund. Generally, for a large cap fund, you shouldn't pay more than 1 percent. For a small cap or international fund, the expense ratio should be less than 1.75 percent.
Since these percentages are broad rules of thumb for actively managed funds, if you favor index funds the expense ratios should be well below these amounts. Usually, you can get excellent funds without paying a load, sometimes called a front-end or back-end load. Also look at the fund's returns. Compare the returns to a benchmark index that is similar to the fund's asset class.
When looking for a mutual fund in which to invest, it's helpful to compare the returns of a fund to the benchmark index for the fund's category. The benchmark indices for three popular asset classes are:
- S&P 500 - for Large Cap U.S. stocks
- Russell 2000 - for Small Cap U.S. stocks
- EAFE Index - for International stocks
The Standard & Poors (S&P) 500 index is an index composed of most of the 500 largest U.S. stocks, in terms of market capitalization. The Russell 2000 is composed of the smallest 2000 U.S. stocks as measured by market capitalization. The EAFE index is prepared by Morgan Stanley and is an index of international stocks and the acronym stands for Europe, Australasia and the Far East.
There are many qualitative factors that you should examine before buying a mutual fund. Look at the fund manager's track record. How well has he performed at the current fund and other funds he or she may have managed in the past? You want to look at the manager's 10-year track record, if available. Some investment advisors examine the manager's track record more closely than the history of the fund itself. After all, what is a fund without the direction of its leader?
Research the mutual fund company overall. How long have they been in business? Does the company have a history of stellar performance and low expenses? How long do fund managers usually last at the fund? Is the manager running several funds, or is he devoted to this fund only? Running several funds may cause a manager to be spread too thin, but if the manager oversees several funds with similar investment styles, this by itself may not be a reason to pass over a fund, since his research for one fund can be used when he chooses investments for another fund that he manages.
Here are some other questions to consider. How fast have assets in the fund grown? Could the growth of assets cause the fund to change investment style? Baron Asset used to be a small cap fund. But the tremendous success of the fund caused a huge inflow of cash and as a result the fund managers chose to invest in larger and larger companies. Additionally, the fund's earlier small company picks did so well that the companies became mid and large cap companies. The mutual fund made a decision not to sell their winners, and the fund became a mid cap fund.
Is the name of the fund consistent with its investment style? Make sure that a fund with a name that connotes investments in small companies truly holds the majority of the fund's assets in small cap stocks.
Tax efficiency is another important issue to consider when choosing a mutual fund. Look at the fund's turnover ratio to determine how often the portfolio manager sells the stocks in the fund. For example, a turnover ratio of 200 means that the portfolio turns over 200 percent a year. If you hold the fund in a taxable account, this means you'll pay capital gains on profits, even if you reinvested the gains into more fund shares. As a general rule of thumb, funds with high turnover ratios (over 60 percent) should be held in your tax-deferred accounts.
If you've narrowed your mutual fund choice down to two finalists, how do you make the final cut? Here are some criteria to consider:
- Favor low fees
- Favor concentrated investing (a smaller number of stocks in a portfolio)
- Favor tax-efficiency
What if you hold a fund that you don't like, but that you acquired a long time ago and the cost basis is very low? It may make sense to sell the fund and incur capital gains, if over a five-year period the performance on the new fund should be at least 5 percent per year better than the performance of the old fund.
Tips Disclaimer
These tips contain information that may change over time as a result of new tax legislation. Although we make efforts to keep this information current, you should check with your tax advisor before taking action based upon any information contained in these tips.