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How to Pick a Mutual Fund

You shouldn’t have to worry about picking mutual funds if you don’t want to.

That is, if you have zero interest in immersing yourself in fund performance data and anlayst research, you will do best with a simple investing strategy: invest in an index fund that tracks the entire stock market.

Why? Because in the long run, actively-managed mutual funds rarely outperform the market.

CHOOSE INDEX FUNDS FOR SELF-GUIDED INVESTMENT

If you are investing on your own for more than 10 years (in an individual retirement account, for example), I recommend investing in a stock market index fund and a bond market index fund with low expense ratios. (Last week, I explained mutual funds costs and their importance to your investment returns here.)

If you plan to invest small amounts over time—monthly, for example—invest directly with the fund company using their automatic investment plan. Find examples from Vanguard, TIAA-CREF, or T. Rowe Price.

If you are investing a lump sum, you may consider an exchange traded fund (ETF) as an alternative.

Later this week I’ll provide some examples of each.

WHEN YOU MUST PICK A MUTUAL FUND…

Sometimes, you won’t be able to choose an index fund in which to invest. For example, your 401(k) or other retirement plan at work will likely ask you to choose from a number of mutual funds. If an index fund in not among them, how do you know which fund is best for you?

There are two areas to consider: 

  • The fund’s suitability to your investing goals.
  • The fund’s management style.

THE RIGHT FUND FOR YOUR GOALS

Long Term
If you’re under 35 and investing for retirement, you’ll want to seek out funds that have the following caracteristics:

  • Invest mostly in stocks (domestic or foreign)
  • Use terms like “aggressive”, “high risk/high return”, or “capital appreciation”
Mid Term

For investing periods of less than 30 years but more than 10 years, look for funds with more moderate risk/reward profiles. These funds will:

  • Invest in a mix of bonds and (mostly domestic) stocks
  • Use terms like “balanced” or “moderate risk”

Short Term
Investing for short-term goals requires a lower risk fund. Look for funds that:

  • Invest mostly in bonds
  • Use terms like “conservative” and “capital preservation”

A note about target-date funds

Target date funds are increasingly popular in 401(k) plans and other plans that provide you, the participant, with limited investment choices.

Target date funds are designed to provide the ideal risk level for a given withdrawal year (most commonly, the year in which you plan to retire). These funds are popular because they make choosing the fund easy and eliminate the need to move money into more conservative funds as you get holder.

To find the right target date fund for you, simply subtract your current age from 65 (or your desired retirement age). Add that number to the current year, and choose the nearest target date fund. Example: I’m 30. 65 – 30 = 35. 2011 + 35 = 2046. I’d pick a 2045 target date fund.

For most investors, target date funds are fine and allow you to “set it and forget it”. Some are better than others. So if you want simplicity, go with a target date fund. If you’re willing to do a bit more work to make sure you’re putting your money in the best place possible, compare facts about the target date fund to other available funds before picking your fund.

DECIPHERING A FUND’S MANAGEMENT STYLE

Found a fund candidate based on your investing objective? Next, review data on the fund on a site like Moringinstar or directly in the fund’s prospectus. Make sure it has:

  • NO load, a sales charge that you should never pay
  • A low expense ratio (under 1%)
  • Low turnover (less than 50%)

To better understand a fund’s load and expense ratio, read last week’s post.

Turnover is the length of time a mutual fund holds stocks. The goal is to find mutual funds that hang onto stocks for a long time, resulting in a lower turnover. This results in lower trading expenses and capital gains taxes.

MUTUAL FUND RETURNS

Obviously, you’re not going to invest in a mutual fund without taking a peek at its historical returns. When you do, remember two things:

  • Consistency is more important than a single blockbuster year.
  • Past performance is no guarantee of future results.

Look for a fund that has done as well, better, or at least almost as well as the overall market year after year. If that fund meets your investing goals and has low expenses, you’ve found a winner.

Check back later this week for a few specific fund suggestions to get you started.

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About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. I like to look at the alpha. In my opinion, it’s the “bang for your buck”… how much return you’ll get for price. Never buy a fund with a negative alpha. The higher the alpha, the better the value.

    PS: sometimes I buy load funds. I don’t believe any article should say NEVER or NO to anything. In certain situations, you might fund a C share fund that out performs any no-load fund.

  2. In my opinion if you don’t want to manage your own portfolio, invest in a couple of low cost index ETFs will do the jobs. It is the best solution for any who want a autopilot portfolio. It is return would outperform a majority of mutual fund portfolio because that mutual fund has a average 1-2% higher fee when compare to ETFs and most of the Mutual fund are underperform to ETFs. So ETFs is the way to go if you don’t want to pick you own stock portfolio.

  3. nancyo – Alpha is too simple of a measure to use in a vacuum. Because the fund’s returns are above its benchmark does not mean that it is superior. In fact, it likely means the fund is taking on excess risk and will almost certainly be a very poor performer in down markets. Look for risk adjusted measures such as Sharpe, Treynor, and Information Ratios.

    Also, I’ll stand with David here and say you should NEVER buy the c share just because the fund outperforms. If there is a c-share available, there will be a no load share class available that will, by definition, outperform the c share net of fees.

    • ah! I meant the sharpe ratio .. not alpha! Thanks for the catch

      If variable share classes are so awful, why are they offered? I believe it depends on the amount you plan to invest, the intended holding period, and what type of sales charge you prefer. There are share classes that can out perform no-load funds. I would love to show you a comparison, net of fees.

      There is always a great debate with MF vs ETF.

      MoneyUnder30 – do you want to write a comparison post of 2 reader portfolio’s of mutual funds vs ETF?

      • Thanks nancyo for the reply. I reread my last post and I think it came off argumentative and that wasn’t my intention. Sorry to sound like Mr. Know-it-all-smarty-pants.

        I ‘d love to see the share class comparison. From my experience share class types are not determined by the investor, but the person selling the fund. A broker sells c-shares because that pay a trail and a-shares because they pay an upfront load. The same fund with no load and no trail has to outperform the fund with a load or a trail, or am I missing something? Maybe you are referring to different managers entirely. If fund manager A offers a no load fund and fund manager B offers a c-share, manager B certainly may outperform net of fees.

        Generally speaking I think staying away from loads can help you avoid biased advice as the person recommending the product has a financial incentive for you to purchase the what he is offering.

        You are right, the active vs. passive debate is a fun one.

    • David Weliver says:

      Both good perspectives, thanks. (And I’ll consider the ETF vs actively-managed mutual fund comparison post—it’s a solid idea.)

      What I’ve tried to do here is simplify the subject of choosing a mutual fund as much as possible, so there are other good ways to screen them, many I would consider more of an “intermediate level”—something to delve into in a future post, again.

      As to “never saying never” regarding buying a load fund, for the purposes of this post, I think it’s fair to say investors should avoid any fund with a load until they have a good reason for choosing that fund over a comprable fund without a load.

  4. Personally, I prefer long-term investing. I believe in thinking long-range. Long-term mutual funds are a good choice in this unpredictable economy.

  5. ETFs and Closed End Funds can be extremely helpful and I prefer them to mutual funds. For me though I am sure it is going to come down to the amount of time and energy I have available. Although ETFs and Closed End Funds are not as volatile as individual securities they do require upkeep work and homework. I like my investments in my own hands but if my hands are too busy with more important ventures mutual funds might be my only answer.

    If you are going with TIAA-CREF they have some really nice options available. Especially for under 30’s concerned with socially responsible investing SRI practices. They have proven consistently in the short period of their management to make favorable returns without the inclusion of common sin stocks. However as always the morality of these securities are always up for debate.

  6. No mention at all of frequency of dividends?? While depending on how much you’ve invested, we’re probably not talking big dollars but every bit helps, especially if you’re buying & holding and select the dividend reinvest option. Got to love free $

    Not to brag, but I bagged $4,900 in dividends this year (granted it is from my whole portfolio) and granted, most of my funds only pay out dividends annually, I do have some that are quarterly or at the vest least, semi-annually.

  7. Mutual funds have sales charges, that can take a big bite out of an investor’s return over short periods of time. Ideally, mutual fund holders should have an investment horizon with at least five years or more.