What to Look for in Mutual Funds – Part 1

I tried my best to make this post concise enough to fit into one post. Unfortunately, I just couldn’t do it. There were too many things that needed to be explained. So, you get the joy of a two part post from me. Today is part one, tomorrow is part two. Enjoy!!

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 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.

So how does one analyze and pick a mutual fund? Below are the first three of five guidelines that I hope will help you out.

1. No Load Funds

A no load mutual fund is one that does not charge a fee, or commission, up front. A front load fund does charge a fee up front. There are plenty of no load mutual funds out there. In fact, studies show that buying a loaded mutual fund is no 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”. 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. 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 %, you still lost money. Please avoid front load mutual funds at all costs.

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.

3. Expenses

The other fee that you get charged is the funds expense. These vary widely. If you are looking at bond funds, the expense ratio for the fund should be around 0.50%. For equities, around 0.75%, and for small international funds, close to 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.

Tomorrow I’ll list two more things you should be considering when investing in a mutual fund.

Tagged as: Investing, Personal Finance Basics, Retirement