When it comes to investing, mutual funds are a great option for many investors. This is because mutual funds allow you to get started investing with a small amount of money and still be diversified from the start. But where do you even start? After all, there are thousands of mutual funds to choose from. This post talks about what to look for in mutual funds. The 5 areas explored here will help you narrow the field of mutual funds down to a more reasonable amount. From there, you can check out my posts on the advantages and disadvantages of mutual funds to knock the list down even further. By the time you get done reading these 3 posts, you should be left with a handful of mutual funds to choose from.
What To Look For In Mutual Funds
With close to 10,000 mutual funds to choose from, how do you know which ones are worth investing in? I did a non-scientific survey of a few random people on the street: Other than relying on their financial advisor to tell them which funds to invest in, the majority responded that they choose which fund to invest in according to the fund’s performance.
The ironic thing with this is that every piece of literature you receive from a mutual fund company states that past performance is not an indication of future performance. The funds are telling you not to pick a fund based on this. Granted, they tell you this in an almost unreadable miniscule font at the bottom of the page. In big fonts are the past performance numbers right in the middle of the page. (Sounds like a conflict of interest to me.) Yet, past performance is how the majority of people pick their investments. The industry knows this, which is why they structure their advertisements this way.
Realize that I was guilty of this myself. Back when I first began investing, I picked a mutual fund based on past performance. It was during the dot-com bubble. I found a fund that returned close to 60% per year for the past two years. I thought that I was going to double my money in less than two years! In fact, after 10 years, I could probably stop working full time!! I poured my money into the fund. That year the fund was down 50%. Then down 35% the next year. I got slaughtered. Never again. (On a side note, I just checked to see if the fund was still around and not surprisingly it is gone. I guess it merged with another mutual fund or simply liquidated it’s assets at some point.)
So how does one analyze and pick a mutual fund? Below are five guidelines that I hope will help you out.
What to Look For In Mutual Funds #1: No Load Funds
A no load mutual fund is one that does not charge a commission to invest in the mutual fund. A front load mutual fund does charge a fee up front. There are plenty of no load mutual funds out there. In fact, there is no proof that buying a loaded mutual fund is better than buying a no load fund in terms of performance. So why is the fee charged? It’s charged by a broker for “helping you pick a fund”. Many times this fee goes into the pocket of the person selling you the fund as a commission. If no one sold you the fund and it still charges a front end load, then the fee goes to the fund company. Save your money and pick funds without a load.
A quick example so you fully understand a load: Say you have $10,000 to invest in Fund A, which charges a 5.75% front load. This means that of your $10,000, you paid $575 to the broker and invested $9,425. Let me repeat that for you. You just paid a broker $575 to invest in a mutual fund when you can do this for FREE. Even worse than this, if the fund charges 1% in expenses and returned 7%, your investment is worth $9,984 after one year. Even though the fund returned 7%, you are still in the hole. Please avoid front load mutual funds at all costs.
What To Look For In Mutual Funds #2: Other Fees
Sadly, some no load mutual funds charge other fees to get around the fact that some people are wise enough to not invest in a front load fund. The big fee is the contingent deferred sales load (CDSL) or back end load. I’ll try to keep this simple. Basically, the fund doesn’t charge you an upfront load. Rather, if you sell your shares before a given time, say five years, then you are hit with a 5% fee when selling.
Luckily for you, it gets more confusing. This fee is reduced each year, so that if you sell in year one, it’s a 5% fee, sell in year two it’s a 4% fee, and so on. After five years, there is no fee. Great, right? Wrong.
In addition to this fee is the 12b-1 fee. This is a “marketing fee” of roughly 1% that you will be charged each year regardless if you sell or not. So, if you choose to sell in year six, even though you didn’t pay the (CDSL), you still paid the 12b-1 fee each year. Hopefully an example will prove helpful.
If you invest $10,000 for six years in a mutual fund that charges a 1% expense fee and a 1% 12b-1 fee and that fund returns 5% per year. After six years your $10,000 is worth $11,871. You paid $1,355 in fees. Compare that to a fund that charges a 0.50% expense fee and no 12b-1 fee. After six years, your investment is worth $13,004 and you paid $352 in fees.
Note that the CDSL and other fees are usually charged on “Class B” or “Class C” shares. If you see this class of mutual fund being offered to you, run. Also, if you invest in some mutual fund “superstore” brokers, like Schwab or Scottrade, some of the fund you invest in will have a 0.25% 12b-1 fee. This is how these discount brokers make their money.
What To Look For In Mutual Funds #3: Expenses
The other fee that you get charged is the fund expense fee (or expense ratio). These vary widely. If you are looking at bond funds, the expense ratio for the fund should be under 0.50%. For equity mutual funds, the fee should be under 0.75%, and for international funds, under 1%. Anything else is excessive. In fact, many reading this may think the numbers I suggest above are excessive. With all else held equal, choose the fund with the lower expense ratio. Why? Because these are fees you pay. They are transparent to you, but you still pay them. Let’s look at an example.
You invest $10,000 in two funds that return 5% in a given year. Fund A has an expense ratio of 1.25%, while Fund B has an expense ratio of 0.40%. In one year, you paid $131 in fees in Fund A while you paid $42 in fees in Fund B.
Now let’s assume you have invested in these two funds for four years. Both funds returned the same 5% per year. In four years you paid $596 in fees in Fund A while in Fund B you pay $193. That’s a difference of close to $400. Over the course of twenty years, you paid an additional $3,800 in fees if you invest in Fund A. Keep your money and pick the fund with the lower fees. You can read this post if you want to learn more about fund expense fees.
What To Look For In Mutual Funds #4: Turnover
Turnover is a measurement of how long a mutual fund holds the stocks or bonds it buys. So, if you see a fund with a turnover of 100%, that is telling you it basically sells out of all of the stocks it invests in each year and buys new stocks.
You may be thinking how does this impact you? Well, it impacts you because each time the fund buys or sells stock, there is a transaction fee the fund is charged. I hope you don’t think that the fund simply eats this cost, because it doesn’t. It passes it through to you, the shareholder. As a side note, there are funds out there that have turnover over 200%! It’s not surprising that the management fee on these funds is sky high. On the opposing end are index funds, whose turnover is close to zero.
What to Look For In Mutual Funds #5: Performance
I realize I told you earlier that past performance is no guarantee of future performance. It’s not. But you can use past performance to gain some insight into the fund. You’ll want to look at the annual returns for the past 10 years. How did the fund do each year? Was it fairly consistent or did it get crushed during down markets and rose exponentially during up markets? Look for consistency. It may not sound fun to invest in a steady performer, but you’ll be thankful for it when the market drops and your fund is riding out the storm.
What To Look For In Mutual Funds: Conclusion
Here are the takeaways for you regarding what you should be paying attention to when investing in mutual funds:
- Never pay a load on a fund. Realize that even if you have a found the greatest fund of all time and it charges a 5.75% load, your fund has to return more than 5.75% just to break even. If your fund returned 10% and the market returns 8%, the market was the better performer.
- Never, ever, ever, pay a contingent deferred sales load (CDSL). It is simply a way to get around calling a fund a front load fund. In many cases, it is actually worse. If there are fees and rules for buying and selling and it confuses you, you are better off not investing in that fund. Additionally, if the person selling you the mutual fund cannot explain the fee structure to you in a way you can easily understand, run.
- Watch expense ratios. The lower the better. Check out Vanguard, Fidelity or T Rowe Price for funds with low expense ratios. If you cannot afford those fund minimums, look into Schwab funds through Charles Schwab or investing through Betterment or Sharebuilder for other low cost mutual funds. You can also check out my online broker comparison chart for more options. If you have no clue what you are paying in mutual fund fees, sign up for a free Personal Capital account and find out.
- Be aware of fund turnover. The higher the turnover, the higher the costs are to run the mutual fund and the more you pay in fees and costs.
- Look at performance, but don’t base your entire decision on it. Find a consistent performer that does well both in good and bad markets. Remember, slow and steady wins the race!
This list of what to look for in mutual funds will get you 90% of the way to being a great investor. To be a complete investor, you need to know what you can control when investing and what you cannot control. You’ll also want to understand what your risk tolerance is as well as making sure your portfolio is diversified. These are all detailed in my post, how to become a stock market millionaire.
Knowing what to look for in mutual funds alone won’t make you a stand out investor. But it will improve your odds of being successful.
For more information on investing, be sure to check out my eBook, 7 Investing Steps That Will Make You Wealthy.