How to Select a Mutual Fund
by Gerald Townsend

Overwhelming choices confront you when choosing among mutual funds. After all, there are more than 10,000 funds clamoring for your attention – and your dollars. Perhaps you use a financial advisor to help you sort through this maze, but even so, being aware of the key factors in the fund selection process will make you a more informed, and better-equipped investor.

Fund Type, Objective & Category
There are basically two types of funds: bond funds and stock funds. Every fund has a stated objective. For example, a bond fund may have an objective of “corporate bonds” or a stock fund could have an objective of “growth and income.” Finally, Morningstar, a mutual fund rating service, divides funds into categories. For example, a stock fund could be in the “large growth” category (meaning that it invests in very large companies, typically trading at high price/earnings ratios) or it might be in the “small value” category (investing in smaller companies that look cheaper according to various valuation measures.)

While these definitions are very basic to many investors, they are also the most important parts of fund selection. The point is you must understand the kind of fund in which you are actually investing, the role played by the fund in your overall portfolio, and you must also develop a realistic expectation of the fund’s potential risk and return.

Performance
Of course, everyone desires investing in funds that provide good performance, but what does good performance actually mean? Over what time periods do you measure it? Performance is best measured in “total return” (income plus gains/losses). Several time frames are useful, such as 1 year, 3 years, and 5 years, but be careful about judging a fund over too short a period of time. Finally, make sure you compare “apples to apples” by benchmarking a fund against its peers (a large growth fund vs. another large growth fund.)

Management Tenure
How long has the same person managed the fund? Would you rather have your money watched over by someone who doesn’t remember a time before the Internet and cell phones or someone who has guided a fund’s shareholders through the ups and downs of many market cycles?

Fund Expenses
Every mutual fund has costs of operations, expressed as an “expense ratio.” Everything else being equal, a lower expense ratio is preferred to a higher one, since fund expenses cost you as an investor. Of course, a fund may provide superior performance or service and justify a higher expense ratio than a competitor. Also, expense ratios, like performance, must be compared with a fund’s peer group.

Fund Size
When a mutual fund becomes popular with investors, its assets swell. The growing size of a fund presents a challenge to the fund company and sometimes the fund simply grows too large to continue providing the performance that attracted investors in the first place. Like many other businesses, sometimes bigger is not better.

Culture & Conviction
While it is difficult to evaluate, the culture of the mutual fund management company and their conviction regarding their investment discipline are key to choosing successful funds. Who wants to put their money with a mutual fund company that was involved in some of the recent trading scandals in the fund industry? Who wants a mutual fund that doesn’t have a consistent and disciplined approach? Who wants to put their money in a fund when the managers of the fund don’t have any of their own money in the fund?

Evaluating a fund is a challenging and ongoing task. There are certainly many other factors that can be considered, such as the number of holdings, tax efficiency, and a host of statistical risk measures; however, this list should give you a good start.