Tuesday, August 7, 2012

What to Look for in a Mutual Fund

Common Sense on Mutual Funds: New Imperatives ...
(Photo credit: Wikipedia)

The hardest part about investing is taking that first step and buying that mutual fund. It can really be confusing because there are over 25,000+ mutual funds spread out in 100's of companies. Finding the mutual fund that is right for you and your goals can be difficult. 

Morningstar.com has an interesting and helpful section on its website called "Investing Classroom". Here you will learn about Stocks, funds, bonds, and portfolios in simple and clear informational classroom style. After each lesson you are quizzed to check your understanding. I found the lesson on what to look for before buying a mutual fund interesting. There were five questions that you should be asking before writing that check.

How has it performed?

Comparing mutual funds is usually done by checking on their percentage performance of the 1 year, 5 year and 10 year time frame. Seeking funds with the highest gains would be your first choice but taking into consideration how a fund compares to funds in the same investment style is also important. You may find a fund that has a great percentage gain but in funds that are similar to it, it may be a laggard.

Many funds compare themselves to index funds like the S&P 500 index which is the industry benchmark. But many funds do not have similar investments to the S&P so it would be unwise to compare it. Finding like mutual funds and indexes that have the same type of investments would be a good way to compare.

How much risk does the fund take?

Investing is inherently a risky pursuit. You will find that the greater the return, the greater the risk so not looking into the risks involved with your mutual fund would not be wise. All mutual funds have risk so your job is to find funds that balance and minimize the risk. Price volatility of a fund is also a consideration. You could find funds with matched returns but the volatility of one could be much higher than the other.

There are four main risk measurements that appear in mutual fund shareholder reports. These include standard deviation, beta, Morningstar risk ratings, and Morningstar bear market rankings. It's also helpful to check out a fund's quarterly and annual returns in different market conditions to get a sense for its potential volatility.

What does it own?

When you buy a mutual fund it is always important to know what the fund owns. Does it have stocks, bonds or both? They all have different characteristics and levels of performance. The gains associated with stocks can be much more than bonds. The fund can own large, medium, and small stocks or a combination of them all. You need to find out what the fund owns so you can make intelligent decisions.

Some fund managers may only have 20 stocks in his portfolio or they may have 200. This amount of diversification may or may not be appropriate for your investment plan. 

Who is the manager and what is their style?

A fund manager that makes the investment decisions for the fund could be a single person or a committee of people. Who is in charge and their style is crucial to the direction and profitability of your investment. Find out if the manager that built the funds great performance is still at the helm. If they moved on, the performance will definitely change.

What are the fees the fund charges?

Your mutual fund has to charge fees to pay salaries, advertise, and generally pay all the bills of the company. Guess who pays them, you do. The fees come out of your investment balance whether you make money or not. It would be helpful to know these fees before you jump in. You may not think a percent or half of a percent is a big deal, but over time the difference really adds up. Seek funds with the lowest fees, it is an important criteria when choosing a fund.

Choosing a mutual fund is not really that hard. On Morningstar.com you can use their mutual fund selection tool to choose the fund that meets all your criteria.

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