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How to Choose the Best Mutual Funds for Your Portfolio

By: , dated January 25th, 2013

Almost 9 out of every 10 investors participate in a mutual fund. At its most basic interpretation, a mutual fund is simply a company, and like any business, a mutual fund exists to make a profit by investing money on behalf of its investors. A mutual fund will typically put together a prospectus for potential investors that states the goals and objectives of the fund. Some mutual funds invest exclusively in stocks or bonds, while others delve into other opportunities for profit. Investors like mutual funds for two big reasons: relatively low risk thanks to diversification and investment minimums as little as $1,000 for some funds. But, before any decisions are made, it is important for investors to choose their mutual funds carefully. There are thousands of mutual funds to choose from and a lot of options to consider.

The Bottom Line – Fees, Expenses, and Loads

Mutual funds have a wide assortment of potential fees that can be charged to investors. While some funds may charge higher fees, they may also yield higher returns – on average. Therefore, fees alone are not the most important criteria to consider when buying a mutual fund, but investors need to understand how they may affect the bottom line of their investment, and factor them into the purchase decision.

Loads are basically sales commissions, and can be charged when investors first purchase the mutual fund, or when they sell it. Many mutual funds may carry a maximum load of up to 8.5%, or a minimum of only 1%. If the sales commission is charged when an investor buys into the mutual fund, it is known as a front-end load. Investors need to carefully consider this option, since front-end loads will eat into the initial investment. For example, if the initial investment was $5,000 and there was a 4% front-end load, then only $4800 would be invested.

A back-end load, on the other hand, charges the sales commission when investors choose to sell their shares of the mutual fund. If the mutual fund has done well, these back-end loads can be pretty steep. But, while the front-end loads can sap into the initial investment and ultimately lower profits, back-end loads can add up to incredibly steep fees. For investors with a smaller initial investment, the back-end loads would probably be the wiser way to go to ensure the largest possible initial investment. Front-end loads would be preferred by those with larger investments. Of course, there are no-load mutual funds (no sales commission at all!!), but they may also have other fees to consider.

Management fees are assessed by mutual funds for the time and expenses related to overseeing the investments. These management fees do not generally exceed 1% of the total value of the mutual fund and its investments, but they can significantly cut into profits—this is especially true the longer the fund is held. For instance, if a mutual fund averaged a 10% return for 20 years with a 2% management fee, then an initial investment of $20,000 would add up to $20,700 in fees by the time it was redeemed. However, if the same investment only had a 0.5% management fee, then it would only add up to $7600 by the time the mutual fund was redeemed – nearly one third of the total fees charged by a mutual fund with a 2% fee! Therefore, it is critical for investors to consider management fees when making a mutual fund purchase, as they can seriously diminish returns. Those mutual funds with management fees in excess of 1% need to be viewed with caution – maybe their returns justify such fees, but past performance is no assurance of future returns!

Other potential expenses to consider are custodian and 12b-1 fees. Custodian fees are charged by the caretaker accountable for the assets in the fund. Banks and trust companies are often responsible for the assets in a mutual fund. The 12b-1 fees relate to any advertising costs the mutual fund incurs while trying to find investors. Be wary of mutual funds with no-loads as they often will have larger 12b-1 and management fees.

Size Does Matter

Not only size, but the age of a mutual fund is very important for investors to consider. Initially, when a mutual fund begins, it is usually small and only contains a few investments in the portfolio. Therefore, one homerun in the portfolio can make the mutual fund look absolutely golden with solid double-digit returns. However, as the fund matures, it naturally diversifies. Even one solid home run in the portfolio of a large and well-established mutual fund will not have the same impact upon returns as one in a smaller, newer fund. It is very important to check the prospectus of a mutual fund to see how old it is, how diversified the assets are, and the annual returns since establishment. Newer funds tend to have truly great returns the first year or so, and then begin to diminish with time. But, while they may be more profitable, they are also more risky, as they are not diversified as well as older funds. For a solid, more stable investment, an older mutual fund with larger assets and more diversification is the way to go. But, for investors hoping to see higher-than-average returns, a newer mutual fund is the better bet – but again, it’s riskier.

Tax Liability

Mutual fund investors need to understand how their tax liability may be affected by potential capital gains. Mutual funds are required to make capital gains distributions any time a security is sold that cannot be offset by selling another one for loss. For this reason, investors should pay attention to when the mutual fund makes distributions. If the mutual fund is purchased before a distribution, the investor may have to pay capital gains on the money received. This will be an especially important point to consider for those investors making large investments in a mutual fund, while those investors spending a $1,000 or so should not have to worry about potential tax liability issues.

Strategy Changes

When a mutual fund fails to meet projections, it is not uncommon to see a shift in investment strategy. This may be due to a recent departure of the portfolio manager or a knee-jerk reaction to bad investments. For instance, a mutual fund may have initially purchased securities and bonds for a portfolio and then suddenly switched to a focusing on commodities.In such a case, none of the historical data for that company is relevant to the current investment strategy shift. Investors should be wary of any drastic or even modest shift towards a new investment strategy as it generally indicates problems of some sort, and also nullifies most historical data relating to the performance of the fund.

Is This a Volatile Fund?

When investors look at the past returns of a mutual fund, it is important they pay attention to the details. It may very well be true that the fund has averaged an 11% return since its foundation 10 years ago. However, as stated earlier, mutual funds have a greater potential for exceptional returns when they are smaller due to the relative size of the portfolio. Therefore, a fund may very well have averaged 15% for the first 1 or 2 years. But, as it diversified and grew larger, the returns of the mutual fund may have diminished to only 6-7% in the past 3 years. So, while the average is 15%, recent performance has not been anywhere near that high water mark. Therefore, investors need to look at the year-to-year returns to make sure that the fund has been steady and consistent. This is especially true for investors looking to only hold onto the mutual fund for a year or two – the more volatile the returns, the greater the risk.

How Much Risk Does the Mutual Fund Take?

To answer this question, investors need to pay close attention to how the fund invests money – its investment strategy. Mutual funds with high rates of return tend to take greater risks than those averaging more modest returns. If the fund has made investments in high-tech stocks a priority, this will naturally be riskier than a fund with a similar percentage of blue chips. Investors need to find funds that take risks in line with their own goals and expectations. To do this, the investment strategy needs to be examined in detail prior to any purchase.

This article was brought to you by the InvestorGuide Staff Writers and Editors.

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