Mutual Funds 101 – 5 Key Criteria for Picking a Mutual Fund

By Jason Van Steenwyk

Congratulations on taking the initiative to learn more about the investment world! It’s vitally important, and no one is going to be more interested in looking out for your future than you are. Mutual funds are crucial investments for most of us – especially for those of us who aren’t covered by a traditional pension plan at work. Mutual fund selection and analysis is a huge subject. But there are five key criteria to be aware of if you’re a beginning fund hunter.

Category

Analysts divide mutual funds into categories depending on what they invest in. A fund that invests mostly in stocks would be called a stock fund, or a growth fund, because most stocks are growth investments. We buy them as much or more on the theory that their share prices will rise than on the expectation of dividend income. However, there are many stocks that pay a healthy dividend.

An income fund, on the other hand, would own securities designed to kick out a reasonably steady income stream, such as bonds. A growth and income fund would combine the two approaches. A bond fund would normally be categorized as an income fund, since bonds generally pay steady interest payments.

International funds would buy investments from outside the United States, while global funds would own investments from all over. In theory, it is good to have some representation in the growth category as well as the income category, plus at least some fund shares in the international or global category. Don’t go overboard in any one direction.

Style

Funds can be conservative or aggressive. Conservative funds are managed with a primary objective of avoiding severe losses. Aggressive funds are managed to maximize long-term gains – even at the expense of short-term volatility. Again, you want a mixture of conservative and aggressive, at least when you’re young. As you get close to retirement age, though, roll back on the aggressive investments and increase your income-oriented holdings.

Also, there are two primary approaches to buying stocks: growth and value. Different managers will have a different style. Growth-oriented managers seek to buy stocks with earnings that are rapidly growing, and will seek to own them even if the share price seems pretty high. The expectation is that the stock’s earnings will eventually catch up and then surpass the level that currently justifies the stock price. This style is typically thought of as aggressive.
A value investor, on the other hand, seeks to buy stocks that are priced cheap relative to earnings or assets. When the market realizes the true value of the stock, reasons the value investor, the share price will rise. Meanwhile, the stock will have a ‘floor’ equal at least to the value of the company’s assets if the company shut down tomorrow, paid off all its creditors, sold off all its holdings and sent the proceeds to shareholders.

Expenses

Look for a low expense ratio, relative to other funds in the category. The expense ratio is the percentage you pay the investment company to run the fund for you. The lower the expense ratio, the more of the fund’s returns you get to keep. The lower the ratio the better.  Most of the time, index funds will sport the lowest expenses. These are funds that aren’t managed by a team of analysts trying to buy stocks. Instead, the fund will buy every stock in a given market, such as the S&P 500. An S&P 500 index fund owns all the largest 500 stocks traded on the New York Stock Exchange and only those stocks. The fund gets all the performance of the index, but gives up a much lower expense ratio. In practice, this usually beats more expensive funds with active managers with portfolios trying to beat the market.

Manager Tenure

How long has the manager been on the job? Has it been at least one market cycle? If so, that gives you a chance to look up how skillful the manager has been in good times and bad, compared to others. A manager with a great track record in both up and down markets is rare… but may be worth paying a somewhat higher expense ratio for.

Load or No-load?

Loaded funds carry a sales charge, which goes to pay a commission to the broker or advisor who sold the fund to you. If you need the help picking the fund, it may be worth paying a broker – but you should get some good analysis or assistance for that money. The broker who gets your commission should provide value in some way, through advice, service, analysis, etc. Otherwise, there’s little point in paying a commission to a broker. In this case, or if you are confident in investing on your own, you can save money by buying a no-load fund over the Web.

These are just a few basic criteria. But if you understand them, you are a long way ahead of many investors, who seemingly buy funds at random. More fund criteria are coming in a future article.

Photo Credit: Images of Money

Filed Under: 401Kfinancial educationInvestingMutual FundsPortfolioRetirementROTH IRATraditional IRA

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