How to Pick a Mutual Fund

Many new investors will understand the potential returns that mutual funds have to offer, but often they will have no idea how to pick a mutual fund. If the truth be told, it is actually relatively easy to study, research, and then pick out a good mutual fund, and often people admit that once they have done this a few times, they get a great thrill from seeking out new and valuable investments.

There are two main camps when it comes to picking a mutual fund. Firstly, there are those who believe it is best to invest in actively managed funds that are known to outperform their peers and indeed their indexes over time. However, the second school of thought is that the only type of mutual fund that is worthwhile investing in is index funds. Index funds are very different from actively managed funds, in that they are typically managed by computers and mathematical computation.

People who are fanatics of index funds are affectionately referred to as Bogleheads, and are named after the index fund and Vanguard founder, John Bogle. And they believe that index funds will consistently outperform actively managed funds over time. However, below there are a few general guidelines on how to pick an actively managed mutual fund, and how an investor can compare them to their index fund counterparts.

Expense ratio – Investors should always be wary of a mutual fund that has a particularly high expense ratio. It is recommended that no fund should be purchased if the overall annual expense ratio is greater than 1.2%. In fact, there are many good mutual funds that can be found that have an expense ratio lower than 1%.

Fund manager history – Industry experts believe that it is not actually the fund that matters so much when investing in mutual funds, but success has far more to do with who is selecting the investments. The main benefit in purchasing an actively managed fund is that the investor has actually purchased the skills and knowledge of that fund’s particular manager.

A good fund manager will initially need to prove that they have sustained long-term success over a period of at least 5 years. They should also display loyalty to the fund that a person is looking to invest in, as if they move on they will, of course, take their skills with them. Finally, it is important to find a fund manager that has an investing philosophy that is in line with that of the potential investor that wishes to hire them.

Load or no-load – If a fund has a load it will have an additional management fee that will claim a certain percentage of a customer’s investment whenever they choose to move in or out of a fund. This can often be as high as 4%-6%, and therefore funds with loads should be avoided if at all possible. This is especially true if there are a number of equally or better performing funds that don’t carry a load.

Net assets – There is such a thing as a fund getting too big when it comes to investing in mutual funds. Many great performing mutual funds will attract performance chasing investors, and unfortunately the more money a fund has to invest the less flexible it becomes. It is advisable to avoid actively managed mutual funds that exceed $10 billion in net assets.

In fact, if a mutual fund reaches this level there is no real advantage to picking it over an index fund counterpart. This is the main reason that many fund companies create “sister” funds which mirrors the exact strategy of the original fund.

Performance – If an actively managed mutual fund is underperforming, an investor is better off saving on expenses and going with the index fund. An investor should really be looking for funds that have long-term sustained success of at least 5 years, although preferably this should be 10 years.

Once an investor has found a mutual fund that contains these 5 metrics they should research the fund further. This can be completed be checking with a major investment aggregator such as the Yahoo Finance fund screener or Morningstar’s mutual fund screener. These aggregators will contain a number of tools to check on funds, as well as a general prospectus on any funds an investor is thinking of purchasing.

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