How To Choose the Best Mutual Funds

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After several posts about the basics of mutual funds, today we can finally get to the most important issue — how do we choose which mutual fund will be a good investment?  This is one of my most important blog posts to help you invest well.  There are thousands of mutual funds based upon every imaginable investing style, that try to balance or hedge risks, that combine stocks and bonds, and even that try to go opposite of the market.  So how do you choose?

The most obvious way is not generally the most profitable.  It is so tempting to buy the hottest funds of the month and hope they continue to zoom up.  Unfortunately, by the time you spot that hot fund, its rise may already be nearing its end and you may even be buying at its peak.  This is how too many investors buy high and sell low.  Plenty of funds have short-term hot streaks, but the top performing funds of any quarter change rapidly and frequently.  To get in that spotlight may mean that they are different from other funds, took on more risk, are less diversified, or got lucky with a pick or two.  Alas, past performance is not a reliable indicator of future performance.

Your mutual fund investing will be more profitably in the long run if you choose good funds with strong long-term performance records, low expenses, tax efficiency, and proven managers.

Long term records

Look for funds that consistently rank near the top of their categories over multiple time periods.  While immediate past performance is not a guarantee of continued future performance, it is important to review a funds long term past performance over multiple time periods.  Review a fund’s performance over the past 1, 3, 5, and 10 years performance to find funds that aren’t necessarily hot now, but have demonstrated consistent performance over many years and several types of market climates.  For example, review a fund’s performance during the 2008 crash, 2009 bottom, and 2010-2013 bull recovery to see how a potential fund performed in several market environments.  Compare the records of your potential pick with its peers and an appropriate index that matches your fund; for example, match a small company fund against a small company index.

 Cost of investing

The more costs you pay to invest, the less you get in returns.  The higher the expense ratio for a mutual fund, the less likely it can beat its competitors or even match its equivalent index.  You cannot reliably predict a fund’s performance, but you can easily see its costs and expense ratio that you will be paying indefinitely.  One of the most important factors in choosing a mutual fund is to compare its “expense ratio” which is the total of all its annual expenses divided by its average net assets.  You can find this ratio on the fund’s website or prospectus as well as numerous websites that provide mutual fund comparison information.  Compare a fund’s expense ratio with its peers and avoid any that are much higher than average.  Average expense ratios can vary over time and by fund type, but in general, avoid stock funds with ratios above 1.5 and bond funds above 1.0.  Moreover, studies have found that funds with expense ratios that are among the lowest 20% in their categories also tend to be among the best in their categories in performance.

Here is a website where you can look up and compare expenses for most mutual funds:  http://www.sec.gov/investor/tools/mfcc/mfcc-int.htm

 Tax – efficiency

For both individual stocks and bonds as well as their mutual funds, you will have to pay taxes on your dividends (unless they are tax free government bonds) and capital gains taxes when you sell them for a profit.  But there is a key tax difference with mutual funds.  Mutual funds buy and sell securities throughout the year and shareholders will have to pay taxes on those “capital gains distributions” annually even if you don’t sell your shares or do buy them late in the year.  The less you pay in mutual funds taxes, just as with mutual funds expenses, the better your return, so look for funds with a good tax efficiency.

Mutual funds are required to report their tax efficiency and this may be one of the factors you want to compare when selecting funds or decide which funds to put in your tax-deferred retirement accounts or regular taxable accounts.

 Managers’ performance

Since professional management expertise is one of the things we are paying for when investing in mutual funds instead of our own stock picking, many experts recommend we review the records of individual manager’s when buying or selling a particular mutual fund – even to consider selling a fund when a manager leaves.  This may be a nice factor for other experts with time to review, but I’m not convinced this is something that individual investors can pay much attention to.  How many of us really know the difference between the shooting stars and real star performers of the mutual fund world like we do in our favorite sports world?  Nonetheless, some web mutual fund screeners do provide this information.

The correct way to choose funds is to select funds that are consistent with your savings time horizon, match your desired investing style and goals, have a strong long-term performance record,  and provide low expense ratios and a good tax efficiency.  Next up, we’ll finish our mutual fund discussion and provide websites that will help you apply these rules to pick the right investment.

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