On the surface, selecting a mutual fund to invest seems to be a complex exercise. There are thousands of funds to choose from, and they are scattered among dozens of investment categories. How can investors find the best funds that fit their needs, goals, and risk tolerance?
Answering the following questions can help you to achieve your task.
How has it performed?
Some might say a fund that returned 10% per year for the past five years is better than a fund that returned 6% per year over the same period. That’s not necessarily true. The fund that gained 6% may have beaten its peers who invest similarly by several percentage points, while the 10% gainer may have lagged its competitors by a mile. Further, both funds probably practiced very different investment styles and invested in different types of securities. To really know how well a fund is doing, put a fund’s returns into context. Compare the fund’s returns to appropriate benchmarks – to indexes and to other funds that invest in the same types of securities.
How risky has it been?
The act of investing involves risk. After all, you’re choosing to give your money to a portfolio manager rather than depositing it into a savings account. Generally, the greater the potential return of an investment, the greater the chance of loss. Investors who take on a lot of risks expect a greater return from their investments, but they don’t always get it. Conversely, other investors are willing to give up the potential for large gains in return for a more probable return. That’s why it’s important to consider risk – both in terms of how much risk you can tolerate and how much risk is appropriate for your goals. Two funds with similar performance might not be equally attractive investments; one could be far more volatile than the other.
What is in its portfolio?
To set realistic expectations for what a fund can do for you, it’s important to know what kinds of securities it owns: Stocks? Bonds? Both?
Because these broad asset classes have different characteristics, don’t expect them to perform the same way. For example, most investors wouldn’t hope for a 10% gain from a bond fund, but that kind of return may not be an unrealistic expectation for certain stock funds. Further, understand the fund’s investment process – the criteria it uses to choose securities within that given asset class.
Who is the chariot of the fund?
Mutual funds are only as good as the people running them: the fund managers who make the investment decisions and the organizations behind them. Because fund managers are most responsible for a fund’s performance, it’s important to know who calls the shots for your mutual fund – as well as how long he or she has been doing so. Make sure that the manager who built the majority of the fund’s record is still the one in charge.
What is its expense ratio?
Mutual funds aren’t free. You should pay for professional money management if you need it. But every penny that you give to fund management or to brokerage commissions is a penny you take away from your own return. Further, costs are one of the few constants in investing: They’ll remain a pretty stable year in and year out while the returns of stocks and bonds will fluctuate.
You can’t control the whims of the market, but you can control how much you pay for your mutual funds.