6 Rules For Picking The Right Mutual Fund

Ask any financial advisor or money manager, and they’ll tell you… A well-diversified portfolio should consist of actively managed investments as well as passive investments.

As StreetAuthority readers, most of you are looking for individual stocks to buy. Some look for dividend yield, while others look for outsize returns. Either way, you most likely understand the importance of carefully choosing your active investments.

Combining the personally passive aspect of professionally managed mutual funds to your portfolio creates another layer of diversification. This can enhance the overall safety of your principle, as well as enhance returns. Just like when choosing individual stocks, you should follow specific guidelines for selecting mutual funds best suited for your portfolio.

There are about 8,000 mutual funds offered by brokers, advisors and banks. All of these funds are competing for your investment dollar.

How can you be confident you’re choosing the right fund? Here are six basic rules to follow:

Rules For Picking The Right Mutual Fund

1. Focus Only On The Long Term
Mutual funds are generally for long-term holding periods. Even the top-performing funds have winning and losing streaks. Don’t let the short-term performance of a mutual fund cloud your judgement about whether the fund makes sense for you.

Take the Buffett philosophy to heart when it comes to mutual-fund time frames. This means, ideally, the minimum time frame to consider is five years when evaluating mutual-fund performance.

2. Know Yourself
Understanding your goals and risk tolerances can help you choose the right mutual fund.

Are you willing to sit through a large drawdown if the fund has proven to outperform over the long term? Do you prefer smaller gains but smaller losses to large gains and large losing periods?

Everyone is different in this regard. Knowing yourself and your goals can help you narrow down the mutual-fund choices.

3. No Sales Charge
Sales charges are also known as commissions or loads. Some funds have front-end charges, which are like commissions when you purchase the fund. Others charge redemption or back-end load fees when you sell. If possible, try to avoid funds that charge these types of fees.

4. Watch The Expense Ratio
This represents the annual fees charged by the fund. These fees can include operating expenses, distribution fees, management fees, and administrative costs.

Fees can range from 0.20% of assets for index funds to 1.5% of assets for actively managed funds. Fees are a huge part of the fund’s overall performance. In fact, history has shown that any fund that charges more than 1% per year will likely underperform the total returns of an index fund.

As you can see, fees and costs are critical components of a fund’s overall performance. Make certain the fees and costs are not above the average.

5. Low Turnover
Turnover is the measurement of how long a mutual fund holds onto the stocks it buys. The longer a mutual fund holds on to stocks, the lower the turnover. Turnover is synonymous with transaction costs. This is because every time the fund buys or sells a stock, it pays transaction fees such as commissions.

Turnover is generally measured on an annual basis, therefore funds with a 100% turnover completely change their holdings every year. The average turnover for mutual funds is 89%, and index funds average 5%. Try to find funds (other than index funds) with turnover under the average for the best long-term performance.

6. Risk-Adjusted Returns
It’s not just the mutual fund’s long-term returns you should consider. The concept of risk-adjusted return needs to play heavily in your analysis. Stated simply, risk-adjusted return measures how much risk was taken to achieve the percentage return.

The five principle risk measures are alpha, beta, R-squared, standard deviation, and the Sharpe ratio. Each of these measurements can be used to quantify the risk-adjusted return of a mutual fund. We won’t get into the details on each of these today, but they’re worth looking into.

Action To Take

Believe it or not, a majority of mutual funds do not beat the indexes over time. That’s why choosing your mutual-fund investments carefully can help put the odds of success on your side. This is particularly true if you’re going the actively-managed route.

For those who want a passive option, we’re fans of Vanguard’s index funds. Not only did Vanguard help pioneer the index fund movement, the low fees and expense ratios offered help keep costs low. That said, many other brokerages and firms have followed suit and offer similar options.

Whichever route you choose, services such as Morningstar and Kiplinger offer mutual-fund screening tools to help discover the right mutual fund for you.

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