Are you thinking about investing in a mutual fund, but aren’t sure how to go about it or which fund is the most appropriate based on your needs? You’re not alone. However, what you may not know is that selecting a mutual fund is much easier than you think.
Identifying Goals and Risk Tolerance
Before investing in any fund, you must first identify your goals for the money being invested. Is your objective long-term capital gains, or is current income important? Will the money be used to pay for college expenses, or to fund a retirement that’s decades away? Identifying a goal is an important step in whittling down the universe of more than 8,000 mutual funds available to investors.
Finally, the desired time horizon must be addressed. How long would you like to hold the investment? Do you anticipate any liquidity concerns in the near future? Mutual funds have sales charges and that can take a big bite out of your return over short periods of time. To mitigate the impact of these charges, an investment horizon of at least five years is ideal.
Style and Fund Type
The primary goal for growth funds is capital appreciation. So If you plan to invest to meet a longer-term need and can handle a fair amount of risk and volatility, a long-term capital appreciation fund may be a good choice. These funds typically hold a high percentage of their assets in common stocks and are, therefore, considered to be volatile in nature. Given the higher level of risk, they offer the potential for greater returns over time. The time frame for holding this type of mutual fund should be five to 10 years at least.
Growth/capital appreciation funds generally do not pay any dividends. So, if you need current income from your portfolio, an income fund may be a better choice. These funds usually buy bonds and other debt instruments that pay interest regularly. Government bonds and corporate debt are two of the more common holdings in an income fund. Bond funds often narrow their scope in terms of the category of bonds they hold. Funds may also differentiate themselves by time horizons such as short, medium or long term.
- Interest rate risk is the sensitivity of bond prices to changes in interest rates. When interest rates go up, bond prices go down.
- Credit risk is the possibility that an issuer could have its credit rating lowered. This adversely impacts the price of the bonds.
- Default risk is the possibility that the bond issuer defaults on its debt obligations.
- Prepayment risk is the risk of the bond holder paying off the bond principal early to take advantage of reissuing its debt at a lower interest rate. Investors are likely to be unable to reinvest and receive the same interest rate.
However, you may want to include bond funds for at least a portion of your portfolio for diversification purposes, even with these risks.
Charges and Fees
Mutual fund companies make money by charging fees to the investor. It is important to understand the different types of fees associated with an investment before you make a purchase.
Some funds charge a sales fee known as a load, which will either be charged at the time of purchase or upon the sale of the investment. A front-end load fee is paid out of the initial investment, when you buy shares in the fund, while a back-end load fee is charged when you sell your shares in the fund. The back-end load typically applies if the shares are sold before a set time period, usually five to 10 years from purchase. This is intended to deter investors from buying and selling too often. The fee is the highest for the first year you hold the shares, then dwindles the longer you hold them.
Front-end loaded shares are identified as Class A shares, while back-ended loaded shares are called Class B shares.
Both front- and back-end loaded funds typically charge 3% to 6% of the total amount invested or distributed, but this figure can be as much as 8.5% by law. The purpose is to discourage turnover (which can be detrimental to the investor) and cover administrative charges associated with the investment. Depending on the mutual fund, the fees may go to the broker who sells the mutual fund or to the fund itself, which may result in lower administration fees later on.
There’s a third type of fee, called a level-load fee. The level load is an annual charge amount deducted from assets in the fund. Class C shares carry this sort of fee.
No-load funds don’t charge a front- or back-end load fee. However, the other fees in a no-load fund, such as the management expense ratio and other administration fees, may be very high.
Other funds charge 12b-1 fees, which are baked into the share price and are used by the fund for promotions, sales and other activities related to the distribution of fund shares. These fees come off of the reported share price at a predetermined point in time and as a result, investors may not be aware of the fee at all. The 12b-1 fees can be, by law, as much as 0.75% of a fund’s average annual assets under management.
One final tip when reviewing mutual fund sales literature: Always look at the management expense ratio. That figure can help clear up any and all confusion relating to sales charges. This ratio is simply the total percentage of fund assets that are being charged to cover fund expenses. The higher the ratio, the lower the investor’s return will be at the end of the year.
Passive Vs. Active Management
Determine if you want an actively or passively managed mutual fund. Actively managed funds have portfolio managers who make decisions regarding which securities and assets to include in the fund. Managers do a great deal of research on assets and consider sectors, company fundamentals, economic trends and macroeconomic factors when making investment decisions. Active funds seek to outperform a benchmark index, depending on the type of fund. Fees are often higher for active funds. Expense ratios can vary from 0.6 to 1.5%.
Passively managed funds, often called “index funds,” seek to track and basically duplicate the performance of a benchmark index. The fees are generally lower than they are for actively managed funds, with some expense ratios as low as 0.15%. Passive funds do not trade their assets very often, unless the composition of the benchmark index changes. This results in lower costs for the fund. Passively managed funds may also have thousands of holdings, resulting in a very well-diversified fund. Since passively managed funds do not trade as much as active funds, they are not creating as much taxable income, which can be an important consideration for non-tax-advantaged accounts.
There’s an ongoing debate about whether actively managed funds are worth the higher fees they charge. The S&P Indices Versus Active (SPIVA) report for 2017 (released in March 2018) showed that, over the past five years and the past 15 years, no more than 16% of managers in any category of actively managed U.S. mutual funds beat their respective benchmarks. Of course, most index funds don’t beat the index, either: Their expenses, low as they are, typically keep an index fund’s return slightly below the returns of the index itself. Nevertheless, the failure of actively managed funds to beat their indexes has made index funds immensely popular with investors of late.
Evaluating Portfolio Managers and Past Results
As with all investments, it’s important to research a fund’s past results. To that end, the following is a list of questions that prospective investors should ask themselves when reviewing a fund’s track record:
- Did the fund manager deliver results that were consistent with general market returns?
- Was the fund more volatile than the major indexes (meaning did its returns vary dramatically throughout the year)?
- Was there unusually high turnover (which can result in larger tax liabilities for the investor)?
The answers to these questions will give you insight into how the portfolio manager performs under certain conditions, and illustrate the fund’s historical trend in terms of turnover and return.
Prior to buying into a fund, it makes sense to review the investment manager’s literature. The fund manager should give you some sense of the prospects for the fund and/or its holdings in the year(s) ahead and discuss general industry and market trends that may affect the fund’s performance.
Size of the Fund
Typically, the size of a fund does not hinder its ability to meet its investment objectives. However, there are times when a fund can get too big. A perfect example is Fidelity’s Magellan Fund. In 1999, the fund topped $100 billion in assets and was forced to change its investment process to accommodate the large daily (investment) inflows. Instead of being nimble and buying small- and mid-capstocks, the fund shifted its focus primarily towards larger capitalization growth stocks. As a result, performance suffered.
So how big is too big? There are no benchmarks set in stone, but $100 billion in assets under management certainly makes it more difficult for a portfolio manager to efficiently run a fund.
History Often Doesn’t Repeat
We’ve all heard that ubiquitous warning: “Past performance does not guarantee future results.” Yet looking at a menu of mutual funds for your 401(k) plan, it’s hard to ignore those that have crushed the competition in recent years.
But are historical outcomes a good indicator of results down the road? The data would seem to indicate otherwise. One study looked at mutual-fund data over a 16-year period and found that just 7.8% of the top 100 fund managers in any given year retained that distinction the following year.
A separate report by Standard & Poor’s showed that only 21.2% of domestic stocks in the top quartile of performers in 2011 stayed there in 2012. And slightly more than 7% remained in the top quartile two years later.
Subsequent Performance of Mutual Funds in the Top Quartile in 2011
Source: Standard & Poor’s
Why are past results so unreliable? Shouldn’t star fund managers be able to replicate their performance year after year?
Certainly, some actively traded funds beat the competition fairly regularly over a long period. But the inherent unpredictability of the market means that even the best minds in the business will have bad years.
A study by investment firm Robert W. Baird & Co. looked into this phenomenon. What the company found was that, even among fund managers who outpaced the market over a 10-year period, many experienced two- or three-year stretches during which they trailed the pack.
Translation: When looking at a fund’s recent outcomes and the numbers look unimpressive, it’s hard to tell if it’s a bad manager having a bad year or a good manager having a bad year.
There’s an even more fundamental reason not to chase high returns. If you buy a stock that’s outpacing the market – say, one that rose from $20 to $24 a share in the course of a year – it could be that it’s only worth $21. And once the market realizes the security is overbought, a correction is bound to take the price down again.
The same is true for a fund, which is simply a basket of stocks or bonds. If you buy right after an upswing, it’s very often the case that the pendulum will swing in the opposite direction.
What Really Matters
Rather than looking at what happened in the past, investors are better off taking into account the various factors that do influence future results. In this respect, it might help to learn a lesson from Morningstar Inc., one of the country’s leading investment research firms.
Since the 1980s, the company has assigned a star rating to mutual funds based on risk-adjusted returns. However, research showed that these scores demonstrated little correlation with future success.
Morningstar has since introduced a new grading system based on five P’s: Process, Performance, People, Parent and Price. With the new rating system, the company looks at the fund’s investment strategy, the longevity of its managers, expense ratios and other relevant factors. The funds in each category earn a Gold, Silver, Bronze or Neutral rating.
The jury’s still out on whether this new method will perform any better than the original one. Regardless, it’s an acknowledgment that historical results, by themselves, tell only a small part of the story.
If there’s one factor that does consistently correlate with strong performance, it’s fees. This explains the popularity of index funds and ETFs, which, at a much lower cost than actively traded funds, mirror a market index.
It’s tempting to judge a mutual fund based on recent returns. But if you really want to pick a winner, look at how well it’s poised for future success, not how it did in the past. For background, check out our Mutual Fund Basics Tutorial and 3 Strategies for Trading Mutual Funds.
The Bottom Line
Selecting a mutual fund may seem like a daunting task, but doing a little research and understanding your objectives and risk tolerance is half of the battle. If you carry out this due diligence before selecting a fund, you’ll increase your chances of success.
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