FOOL'S SCHOOL DAILY Q&A

Finding the Best Fund

Q: I know your position on investing in mutual funds. But what if that is all that is available in my retirement plan as a civil servant? How do I choose the best one when the majority have only been around three to five years? -- S.R., via the Internet

A: Our position on mutual funds, for those who might not know it, is that eight out of 10 of them underperform the market average. In recent years, in fact, the ratio is nine out of 10. This means that if you're in a mutual fund, there is a 90 percent chance that you'd do better to be in a no-load index fund, which simply tracks the market as a whole.

But what if you can't invest in a no-load index fund? Municipal governments in particular tend to favor load funds.

What's a load? Mutual funds come in two broad categories: those that have a sales charge and those that do not. Those that have a sales charge are called load funds; those that do not are called no-load funds. When a broker recommends a fund to one of her clients, it's probably a load fund. The load, or sales charge, is pocketed by the broker and/or other middlemen as payment for the "service of helping you pick a good fund."

There is no significant difference historically between the performance of load funds and no-load funds in terms of year-to-year performance. However, according to the latest survey by the mutual fund data analyzer Morningstar, no-load funds actually have a superior record to load funds over the last three- and five-year periods.

Let us repeat that: Funds that impose no cost to purchase have outperformed those funds that brokers pay themselves to find for their clients.

Now when you indicate that most of these funds haven't been around longer than three to five years, we're not surprised. A huge number of funds have been created in recent years to capitalize on the stock market's popularity. But we don't think that three to five years is nearly ample enough time to judge how the fund will do in the future.

In selecting from the funds available to you in your plan, you should determine the "expense ratio" of each of the funds. The expense ratio shows how much money the fund charges its shareholders every year so that it can operate and the fund manager can take lavish vacations. The average expense ratio tends to be around 1.5 percent for a stock mutual fund. Find a low expense ratio fund -- one that charges less than 1 percent annually. Also try to find a fund whose lifetime returns are closest to those of the S&P 500. That is, try to find a fund that is close to an index fund. Find out which stocks that fund holds currently. With any luck, it will include some of the heavyweights of the S&P 500, and that's why its results have fairly closely approximated those of the S&P 500. And if you can, lobby the powers that be at your employer to include index funds as an option. Call your friends and co-workers. Create a groundswell. Change the world!

WHAT NOW? You may be bamboozled by a host of terms thrown at you about the funds that are offered by your retirement plan: 12b-1 fees, front-end loads, back-end loads and so forth. You'll find these terms explained here. And the Securities and Exchange Commission has an excellent mutual fund cost calculator.

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