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Get More From Your Mutual Funds

The Motley Fool has always had a very simple message when it comes to mutual funds: "Buy an index fund." It's a solid approach, one that enables investors to outperform most actively managed funds and approximate the stock market's average return, year-in, year-out.

Nevertheless, lots of people -- including Fools -- invest in managed funds, either for variety or because they're in a retirement plan that doesn't give them any choice. Managed funds (as opposed to passive index funds) are fine, but unless you track their performance precisely, your returns may suffer.

For example, how do your mutual fund's fees compare to others in its class? What about turnover and its tax consequences? Not sure what we're talking about? Then read on. While the Fool has discussed these matters before, we're expanding our analysis of mutual funds in order to provide investors with the necessary tools to get the most from their funds, and offering a mutual fund seminar for those interested in learning more.

Everyone loves funds
Despite the Fool's oft-stated preference for index funds, millions of Americans, amazingly enough, ignore this advice and continue to invest in managed funds. In fact, as of the end of 1999, there was a whopping $6.8 trillion -- equal to about two-thirds of annual U.S. economic output -- held in 228 million different mutual fund accounts. While these are huge numbers, they're not surprising when you consider that many people have little choice. After all, pretty much everyone with a 401(k) has to choose some kind of mutual fund for their savings. Here at the Fool, for example, our 401(k) plan offers 18 different mutual funds, including an index fund, of course.

So how do most Fools, and how should you, evaluate all these different choices? That's what we'll discuss in this article. 

No excuse for laziness
Let's begin with attitude. Mutual funds may be a simpler way to invest your money, compared to researching and buying individual stocks, but that does not absolve you of all work or effort. Whether you own funds through a retirement plan or in a brokerage account, you'll want to take an active approach towards evaluating them.

"Well, duh," you say. "Of course I evaluate my mutual funds before I invest in them." Fine, but we're not just talking about checking out ads in personal finance magazines to compare the carefully selected returns of funds that are willing to spend their customers' money on the ads. We all know that some mutual funds do better than others, but there's a lot more to it than just raw performance. There are also sales charges, turnover, taxes, and other factors to take into account. This is your money we're talking about, so let's make sure it's well spent!

What difference does it make?
Ah, glad you asked. As you save for retirement, even just one or two percentage points difference in annual return rates can have a significant effect. While perhaps not the difference between eating caviar or cat food, it adds up. For example, $10,000 placed in a mutual fund for 30 years, earning the market's average annual return of 11%, will grow to $229,000. The same amount, growing for the same length of time, but at 10% instead, will add up to $175,000. That's a $54,000 difference, which could get you a decent sailboat, or some other equipment for a nice, expensive hobby.

What's more important, though, is that it's not just up to your fund manager to do 1% better. You can make that 1% difference -- or more -- by choosing the right fund. Let's look at some of the steps you can take to accomplish this. 

Low fees, no loads
If you're not familiar with why the Fool has always preferred index funds, we've got a full explanation in our mutual funds area. Let us save you some time, though: The explanation pretty much boils down to the higher expenses that managed funds charge. In fact, in many cases, mutual fund managers choose stocks that do well, but the funds end up losing to the market indices because the annual expenses they charge outweigh the performance of the stocks they select.

On average, managed mutual funds charge an annual expense fee of around 1.5% of assets, and another 0.7% gets eaten up in transaction costs. In addition, there are front-end or back-end "loads," or sales charges, that some funds levy when you buy or sell your shares. These loads provide little benefit to the shareholder, and there's no evidence that funds with loads perform better than those without.

What you can do: Avoid mutual funds that charge loads, whether up-front or upon redemption of your shares. In addition, compare mutual funds with similar goals and asset classes (large-cap growth or small-cap value funds, for example) and choose those with lower annual expenses. Even index funds that track popular indices, such as the S&P 500, can vary widely in their fees. Several websites, such as Morningstar, carry this information.

After-tax returns
Unless your funds are in a nontaxable retirement account, taxes can have an even bigger impact on managed funds than expenses and fees. According to a recent study by accountants at KPMG, the average stock fund sacrifices 2.5 percentage points of its return to taxes, a fact that you won't find in the average mutual fund ad. However, thanks to a recent SEC ruling, you will soon be able to find this information in the prospectuses that mutual funds send out. And when you consider the difference that 1 percentage point makes, then the impact of 2.5 percentage points should be clear. 

Mutual funds are taxed on dividends and interest, as well as capital gains that result from trading. As funds trade more frequently, increasing the turnover of shares in their accounts, they incur greater capital gains taxes. As a result, generally speaking, the greater the turnover, the higher the tax bill.

What you can do: This is another area where index funds excel, since their turnover is generally low, but there is still plenty of variation between managed funds on this score. Between two similar funds, consider buying the fund with the lower turnover in your non-retirement account. Generally, any fund with less than 50% turnover is preferable, and below 20% is ideal (though this is just one factor to consider, of course). Or, confine your investing in managed mutual funds to tax-free retirement accounts.

Conclusion
These two factors are just the beginning. Other factors you'll want to consider when choosing managed mutual funds include: what's in the prospectus, the fund's past performance relative to its relevant benchmark, and the impact of cash reserves on returns.

Our upcoming mutual fund seminar not only discusses all these factors in depth, but it will also look at a variety of different mutual funds, and even select a few Foolish candidates from the thousands of funds grasping for your investment dollars. If you're regularly investing in mutual funds, you'll definitely want to check it out.

Maximize Your Mutual Funds Find out which funds the Fool likes in our Mutual Fund Online Seminar. Hurry -- enrollment ends April 30.

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