Mutual Funds: Basics

How to Choose a Mutual Fund

Mutual Funds

By Bill Barker

If you are selecting actively managed mutual funds of your own volition, or if you are forced to do so because your 401(k) plan does not provide an index fund, you should have the mindset that you are selecting from a universe that underperforms the market and you are primarily attempting to cut your losses. If you think that we can give you a set of directions that are likely to beat the market using mutual funds -- well, we really don't have a system for that and we don't believe anyone else does either. But with the objective of keeping expense ratios and turnover low, you can improve your chances of finding a fund that will not lose badly to the market and improve your chances of finding a fund that holds some promise of outperforming the market.

Yes, each and every year there are some mutual funds that beat the overall market, and there are even years when the majority of mutual funds beat the market. But trying to pick a mutual fund ahead of time that will beat the market is extraordinarily difficult. When "mutual fund experts" are asked to pick mutual funds that they think will beat the market, they almost always fail, typically with disastrous results. In 1998, ten mutual fund experts were asked by USA Today to pick two mutual funds for the year. None, none, were able to pick a fund that beat the market. Studies show that picking mutual funds on the basis of past performance does not work, and saints preserve anyone who picks mutual funds on the basis of screaming magazine headlines.

So, can we imagine a time when a Fool would willingly choose to put his hard-earned money into a mutual fund?

Imagine a Fool walking down the street, innocently minding his own business, thinking only of ways to educate, amuse, or otherwise enrich some of his fellow men. Imagine that the Fool, lost in his thoughts, doesn't notice that the street he is on is Wall Street, and that suddenly he is cornered by an extremely well-dressed gun-toting thug who starts screaming, "We measure success one actively managed mutual fund sold at a time! Pick one now, or I'll blow your head off!"

Seem improbable? It should. It really should. We know Wall Street is full of a lot of irrational people, but we really don't think any of them would do this. We hope not anyway. Time will tell.

But, in reality, many Fools are confronted with the necessity of picking mutual funds from of a selection in their 401(k) plans when an index fund is not one of the options. If you remember what we have described so far in the previous sections, you'll have no problem going about picking a fund. If you skipped some of those articles, fell asleep, got distracted by the television, have short-term memory problems, or just can't get enough reviews of things you've already read once, here are the salient points set forth again.

Your mutual fund shopping list should read:

  1. No sales charges (front loads, contingent deferred sales loads, level loads)
  2. A low expense ratio (below 1.00%)
  3. Low turnover, no higher than 50% a year, and preferably closer to 20%
  4. Full investment policy. Cash reserves of nearly 0%.

And we'll review these concepts again for ya.

Studies show that over time, virtually all of the difference in return between managed funds and index funds is attributable to the higher costs imposed by actively managed funds. These costs come in the form of loads and expense ratios.

You want to make sure that you are not paying any sales charges. Sales charges come in various stripes, also known as loads or commissions. There might be a charge for buying into the fund (a front-end load) or selling the fund (back-end load, deferred sales charge, or redemption fee). Avoid all of these. Some funds have back-end loads that are reduced the longer you hold the fund. Best to avoid these as well. If you have to buy an actively managed fund, buy the fund with no sales charges at all. Funds that normally have sales charges sometimes waive them or have reduced sales charges for large 401(k) accounts.

Expense ratios represent the annual fees charged by all funds, including the management fee, the administrative costs, 12b-1 distribution fees, and other operating expenses. You want to make sure that the fees are as low as possible. Index funds typically charge about 0.20% of the assets, and actively managed funds currently average about 1.5% per year. The average fee, by the way, has actually been climbing in recent years. Any fund that has fees above 1% per year can be expected to underperform the total returns offered by an index fund.

Turnover measures how long a fund holds on to the stocks it buys. The longer a mutual fund holds on to a stock and the less trading the fund does, the lower the turnover will be. Since a fund incurs costs every time it buys and sells stocks (just like you do), the lower the turnover, the lower the transaction costs incurred by the fund -- and the lower the capital gains taxes. Ideally, Fools like to see funds that practice the "buy and hold" method of investing -- those funds are the most index-like. Funds that have a turnover of 100% are essentially buying a completely new set of companies every year. Turnover should ideally be substantially lower than the mutual fund average of about 80%. Index funds have turnover as low as 5%.

A mutual fund that has an established track record is less important than you would think. Studies show that measuring performance over two decades or longer, 99% of funds that outperform the market in one decade revert to the mean in the next decade. Past performance really isn�t an indication of future results. If a fund has outperformed the S&P 500 recently, determine how it does against similar Morningstar style box funds.

Make sure to check out the consistency of the fund's returns. You�re looking for funds that not only have shown good returns on the whole, but ones that do so on a consistent basis, rather than having great runs followed by lousy ones. Most funds that claim to have outperformed the market over a ten-year period really had most or all of their truly good performance when they were young and small. Once the fund has attracted a couple of billion extra dollars, the fund usually starts performing more in line with the market.

For detailed questions about specific funds, look for help by posting your questions on The Fool's Mutual Funds and Index Funds message boards. Also visit our Index Center for detailed descriptions of some well-known indexes.

Keep the fees low and select from low turnover funds and you'll generally outperform most mutual funds. An even briefer summary would be, "Just buy an index fund."

Next: How to Read a Mutual Fund Prospectus »

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