Select a Mutual Fund

A mutual fund is a pool of money collected by many investors that is managed by a Registered Investment Adviser. Mutual fund assets may be stocks, bonds, and/or commodities.[1] Mutual funds include a wider range of investments than individual stocks.[2] This means mutual funds are lower risk, but they also yield lower returns in the short run. For this reason, mutual funds are typically long-term investments. With thousands of options available, selecting the right one for you may seem daunting. With a little research and know-how, though, you can select the right fund for your needs.

Steps

Setting Your Goals and Understanding the Basics

  1. Do a self-evaluation. Before you go any further, it is important to take stock of yourself and determine your "investor profile." Your investor profile defines what you are like as an investor.
    • For example, what are your investment needs? How much risk can you tolerate? How long do you plan to keep your investment? How much do you have to invest? The answers to these questions make up your investor profile. They will also be the first step in narrowing the field of mutual funds to select the one(s) best for you.
    • Time is probably the single most important factor to consider when investing. How long will you keep this investment? When will you need to use the money?
    • If you have a long time to invest, time is on your side. You can afford to take more risk and rebound from any temporary losses. If you have a short time horizon you will likely want to be more conservative. This is because you won’t have as much time to recover from the inevitable losses along the way. In such a case you will value safety above all else. [3] Thus, your time horizon is extremely important in choosing funds.
    • Another important part of this process is determining your risk tolerance. This is a measure of how much risk you are willing to take with your money. [4] If you are going to be anxious when your fund goes up 2% one day and down 5% the next, you should avoid funds with high volatility. This is recommended for beginning investors (until they get a feel for the investment process). Risk tolerance is, in part, determined by investor experience and sophistication. Veteran investors know that stock markets have generally trended up in the past, with periods of decline in the long-term trend.
  2. Understand the differences between funds. Mutual funds can be categorized in several different ways. With thousands of options, its important to understand four major dimensions of mutual funds:
    • Investment category. This relates to the investment style or objectives of the fund manager. There are several different categories to consider. Aggressive growth funds pursue high-risk, high return investments, usually without paying dividends. Returns on these funds come from increases in stock value. Growth funds are similar, but less volatile. Income funds look for investments with moderate growth that pay modest dividends. Value funds seek to invest in stocks that grow only modestly in value, but pay consistent dividends. There are also other categories that may blend these types, or focus investing in some other way (e.g. in bonds or money markets).[5]
    • Size. This dimension relates to the size of the companies are that the fund invests in. Generally speaking, risk decreases as size increases. Large Cap funds invest in big companies, typically valued at $10 billion or more. Mid Cap funds invest in medium sized companies, generally between $2 billion and $10 billion. Small Cap funds invest in small companies. Small companies are more likely to fail, but also more likely to experience rapid growth.[5]
    • Geographic focus. This relates to what part of the world a mutual fund has its investments in. Some funds focus exclusively on US markets, while others focus on other areas of the globe.
    • Primary business sector of investments. This relates to what types of enterprises the fund focuses its investments in. A fund might invest primarily in companies involved in manufacturing, for example, or in agriculture or mineral extraction.[6]
    • In addition to these four dimensions, it is also important to know if a mutual fund is open- or closed- ended. Most mutual funds are open ended, meaning there is no limit to how many people can invest, and the fund is not traded on the exchange. Closed-ended funds have a limited number of shares, and are traded on the exchange. This makes them more volatile.[7]
  3. Understand the difference between mutual funds and ETFs. Many people who invest in mutual funds also invest in exchange-traded funds (ETFs). ETFs are a minimally-managed group of investment securities designed to mimic or track and index such as the S&P 500. There are two major differences between most ETFs and most mutual funds.
    • ETFs are bought and sold on the stock exchange like common stocks. This makes them more volatile, but also more liquid.[8] Like stocks, the value of an ETF fluctuates throughout the day because it is traded on the exchange. ETF will not rise and fall with the market (unless the ETF is S&P 500 or DJIA); it will rise and fall with the underlying index it has been designed to track. But, like a mutual fund, your investment is more diversified than buying individual stocks.[7]
    • Passive ETFs are index funds designed to track a specific benchmarks, such as the SPDR. They are not managed by a fund manager, and will rise and fall with the market as a whole because these funds' investments don't change.[9] This means the fees tend to be lower, but the returns often are too. There are also active ETFs, which are managed, making them more similar to mutual funds.
    • Mutual funds are managed, whereas most ETFs (known as "passive ETFs") are not. This means that the holdings of a mutual fund are selected by a fund manager who seeks to make the fund as profitable as possible. The manager actively monitors the market and revises the fund's assets accordingly.
  4. Learn how to assess a fund's performance. Performance is a measure of how profitable a fund is or has been. When considering a mutual fund, it is important to understand its past performance and compare it to other funds.
    • Historical performance is a measure of how a fund has performed in the past. Performance is measured over a period of months or years. Longer performance periods are more meaningful than shorter ones.[10]
    • When evaluating funds, focus on the long-term historical performance. Specifically, look at a fund's net returns over the last three, five, and ten years. This may seem like a long time, but remember that mutual funds are long term investments. Looking back over a longer period also more clearly outlines the tendency of the fund over time. It will more likely include both rising and falling markets.
    • It is important to remember that past performance is no guarantee of future returns. Even so, it is a useful indicator and especially useful as a valid point of comparison among funds.
    • Relative performance compares a fund's performance to other funds or to a benchmark. A benchmark is a common point of reference for comparison. It could be a stock index like the S&P 500, which is the most widely used benchmark. It could also be another fund or an index created for a specific asset class, fund objective, geographical region or market sector. An example would be the MSCI World Stock Index. [11] Comparing it to one of these benchmarks over a long-term period is an effective way to assess a mutual fund's performance.
    • It helps to know relative performance as well as historical performance. For example, is a 10% return a lot or a little? That will depend on factors such as time, risk, and volatility (among other things). You get much more insight into the meaning of a fund’s return if you can compare it to similar funds or to a benchmark.
  5. Understand the risks and rewards. Risk describes how likely a fund is to lose money during a given period of time. Prices of stocks, bonds and all other types of assets go up and down. How much and how often they go up and down determine the risk. [12] Your goal as mutual fund investor should be to get the highest return with the lowest risk.
    • Investing is all about the risk-return relationship. More risk allows for more reward and more loss. Less risk allows for less reward but also less loss.
    • Risk is typically measured in terms of volatility or “historical volatility”. Volatility is the measure of the breadth of the price change of a security within a specific period of time[13] It describes how much the price of an asset moves over a period of time. The direction it moves is unimportant in the calculation. More volatility means more risk. [14]
    • Returns describe how much a fund gains or loses over a period of time, expressed as a percentage of the whole investment. [15]
  6. Interpret the risk/return relationship. The relationship between risks and returns is often expressed using one or more different ratios. It is important these because they tell you how likely you are to get rewarded for taking on risk. [16]
    • The Sharpe ratio is the industry-standard measure of risk-adjusted return. It is the average return earned in excess of the "risk-free" rate per unit of volatility.[17] A Sharpe ratio above 1 means that historically the fund has earned more than enough to offset and compensate for the risk assumed. A value below 1 means that the risk assumed is insufficiently compensated. In other words, there were more losses than gains. The farther you get from 1, the more you are likely to receive a reward or punishment. [18]
    • "Alpha" compares a mutual fund's performance to a benchmark index, while also taking into account volatility. The fund's returns, relative to the benchmark index, is a fund's alpha. A positive alpha score of 1.0 would mean the fund outperformed the benchmark by 1%. A negative 1.0 alpha score would mean the fund under-performed by 1%.[19]
    • "Beta" describes how closely the fund’s returns track the benchmark's returns. Risk does influence beta, but beta does not measure volatility. Rather, it measures relative price movements. It is a measure of correlation. [20]
  7. Consider the costs. There are costs associated with investing in mutual funds. Some are direct ("loads," which are sales or redemption fees) and others are indirect (overhead expenses).
    • A load is simply a commission paid to the mutual fund company for the privilege of investing in their fund. They are essentially an extra charge for helping your choose a good fund. Loads will diminish the effect that compounding of returns will have for you and thus reduce your returns overall. There are many no-load funds, so you may wish to avoid these costs.[21]
    • Another fee you be able to avoid is the 12b-1 fee. This is a "distribution" and advertising fee and can be used to pay brokers for helping the fund find investors. Many, but not all, funds charge a 12b-1 fee.
    • Some expenses are unavoidable. There are management expenses, costs of buying and selling (trading) and many others. Taken together, these are known as the expense ratio. You compare the expense ratio of one fund to other funds. All things being equal (like risk and return), a lower expense ratio is preferable. [22] The SEC states that there is no evidence that more expensive mutual funds perform any better than less expensive ones.
    • Passive ETFs are frequently the lowest-cost funds. This is because they save lots of money on research, analysis, trading, etc. Typically, these index funds have expenses of less than 0.25%. They are not known for high returns, but they do offer diversified portfolios.

Researching Mutual Funds

  1. Visit MorningStar. MorningStar is one the most respected investment research firms. Their website contains information and news about mutual funds and other types of investments.[23]
    • You can access some of the information available through MorningStar just by visiting the site. Other data requires a membership. The company does offer a free basic membership, however, that will give you access to most of the basic information you need. A premium membership allows you more access, but comes at a cost.[24]
  2. Visit Zack's. Another well-respected source for information about mutual funds and their performances is Zack's. This research firm also provides a lot of useful information, free of charge.[25]
  3. Research fund objectives. Using the sites above, you can begin narrowing down the field of mutual funds. Start by looking at the objectives of the various funds, and try to pick one that aligns with your own objectives and risk profile.
    • Each fund will have a specific objective. You can find it in the prospectus, in MorningStar reports and elsewhere. It gives a simplified idea of what the fund is attempting to do and how it attempts to do it.[26]
    • These objectives should map onto the four dimensions of funds discussed in Part 1.
  4. Compare fund performances. Once you've selected some funds that seem interesting, take some time to see how well they have performed.
    • Look at their historical and relative performances, and collect any other information you can.
    • There are several online sources that can provide this information. Some even allow for side-by-side comparisons of different mutual funds. [27][28]
  5. Look up the inception (origination) date of the fund. This information is available in the prospectus and online sources of financial information.
    • This date is important to know. A longer history is more telling than a shorter history. Having more investing experience is better than having less. A longer period of time allows a more relevant comparison to other funds.
    • It's smart to check how long the fund manager has been in control of this fund (or other funds). It would also be valuable to know if the manager has invested his/her own money in the fund. Morningstar and Lipper are two online sources of such information.
  6. Research the total assets under management. Assets under management (AUM) is a measure of the market value of a fund's investments. [29]
    • You want the fund to be large enough that it demonstrates investor confidence and can handle sudden, large redemptions. However, there's such a thing as a fund being too large. Having too much money under management can make a fund unwieldy and inflexible. This is hard to quantify, but with experience you'll begin to develop a sense about it.
    • This is less important than the other considerations discussed above.
  7. Determine the investment requirements. Each fund will have specific requirements about the minimum amount necessary to open an account. They will also have a minimum for additional purchases. Find one you can afford that meets your investor profile.
    • The initial investment and additional investments might be as little as $100. Some ETFs will permit an initial investment as low as the price of a single share.
    • You will find this information on the website of the fund company as well as in the prospectus for the fund.
  8. Request a prospectus. A prospectus is a long, detailed document. It has all the legal definitions about what the fund can invest in, how it is managed and other legal information. [30] You can have the company send you a hard copy of the prospectus or download it from the website.
    • A prospectus can be overwhelming. The federal government mandates that the most important information be easily found and understood. You can find this information at the beginning of the prospectus. It is often highlighted or italicized. This section is called the summary prospectus.
    • The summary prospectus will describe the fund's investment objectives and strategies. It will also cover the principal risks of investing in the fund and the fund’s fees and expenses. Finally, the summary prospectus will discuss the fund's past performance. You can find more detailed information in the full "statutory" prospectus that follows. This will include information relating to the fund’s investment advisers and portfolio managers. It will also provide details on how to purchase and redeem shares.[30]
    • Most of the relevant information will be available from other sources, such as Morningstar. It's a good idea, however, to read the prospectus for any mutual fund you are seriously considering.
    • For more information on mutual fund prospectuses, visit the SEC website. [30]

Buying and Redeeming Fund Shares

  1. Talk to a banker. Once you have selected a fund or funds that meet your needs, it is time to buy some shares. Shares are your individual stake in the fund. Your bank probably offers mutual funds. You may want to speak with an account representative in your branch to see if they have a fund that meets your objectives.
    • This simplifies the process of opening the account. It also makes it easier to make contributions, redemptions or withdrawals.
    • An added bonus is that you will receive summaries of your spending, saving, and investing activity in one place. This makes it easier for you to review all this information at once.
  2. Go to the fund's website. If you opt not to sign up through your bank, you can contact a stockbroker or go to the website for the fund you've chosen. If the fund allows you to buy shares directly, there will be an option for opening a new account on the home page.
  3. Enter your information. Opening a mutual fund account is like opening a bank account. There will be a simple form for you to input your personal information and to designate the fund you're choosing and the amount of money you're investing. [31]
    • The website will provide detailed instructions for opening an account.
  4. Review and sign. Make sure all the information you've provided is correct and sign the document. You will probably be able to sign electronically.
  5. Buy shares. You should be able to deposit funds using either a check or an electronic transfer from your bank account. [31]
    • Submit the money you want to devote to your initial investment, based on the cost per share and how many shares you wish to buy.
  6. Redeem your shares. Mutual fund shares are “redeemable.” This means you can sell the shares back to the fund at any time.[32] At the point you are ready to cash out your investment, redeem your shares.
    • Mutual funds accept redemptions by telephone or mail.[33] Some mutual funds also can process your redemption online.[34] To find out how to redeem your shares, visit the website of your fund or look in a recent prospectus.
    • The fund usually must send you the payment within seven days.[32]

Tips

  • Remember there is a clear relationship between risk and reward, as well as risk and time. If you can commit money for a long time, taking more risk in your choice of funds will increase the likelihood of greater rewards.

Warnings

  • Don't invest more in an aggressive (risky) fund than you can afford to lose. Although it's unlikely you would lose your entire investment, the more volatile mutual funds can lose a lot of value. This is especially true in the short term. That's why having a long investment horizon is important in most investments.
  • Just because a fund did well last quarter or last year doesn't mean it will do well next quarter or next year.

Related Articles

Sources and Citations

  1. ↑ http://money.cnn.com/magazines/moneymag/money101/lesson6/index2.htm
  2. ↑ http://www.investopedia.com/terms/d/diversifiedfund.asp
  3. ↑ http://www.investopedia.com/terms/t/timehorizon.asp
  4. ↑ http://www.investopedia.com/terms/r/risktolerance.asp
  5. ↑ 5.0 5.1 http://www.investopedia.com/university/quality-mutual-fund/chp3-invest-obj/
  6. ↑ http://www.investopedia.com/terms/s/sector.asp
  7. ↑ 7.0 7.1 http://www.investopedia.com/financial-edge/0712/closed-end-vs.-open-end-funds.aspx
  8. ↑ http://www.investopedia.com/terms/e/etf.asp
  9. ↑ http://www.investopedia.com/terms/p/passive-etf.asp
  10. ↑ http://www.investopedia.com/university/quality-mutual-fund/chp9-perform-metrics/
  11. ↑ http://www.fool.com/School/MutualFunds/Performance/Measure.htm
  12. ↑ http://www.investorwords.com/8620/investment_risk.html
  13. ↑ http://www.investorwords.com/8620/investment_risk.html
  14. ↑ http://www.investorwords.com/5256/volatility.html
  15. ↑ http://www.investorwords.com/2625/investment_return.html
  16. ↑ http://www.investopedia.com/terms/r/riskrewardratio.asp
  17. ↑ http://www.investopedia.com/terms/s/sharperatio.asp
  18. ↑ https://secure.fundsupermart.com/main/research/viewHTML.tpl;FSMAPPID=vyfRvO6Vo5B6e9s2xSw721RvhQknBieui1N5sDiY-k74NeIKdRQD!281136912?articleNo=2387
  19. ↑ http://www.investopedia.com/terms/a/alpha.asp
  20. ↑ http://www.nasdaq.com/investing/glossary/b/beta
  21. ↑ http://www.fool.com/school/mutualfunds/costs/loads.htm
  22. ↑ http://www.investopedia.com/university/mutualfunds/mutualfunds2.asp
  23. ↑ http://www.morningstar.com/funds.html
  24. ↑ https://members.morningstar.com/premium/better-returns.html?referid=A1151&vurl=http://www.morningstar.com
  25. ↑ http://www.zacks.com/funds/
  26. ↑ http://www.investopedia.com/university/quality-mutual-fund/chp3-invest-obj/
  27. ↑ http://www.bloomberg.com/personal-finance
  28. ↑ http://www.morningstar.com/Cover/Funds.aspx
  29. ↑ http://www.investopedia.com/terms/a/aum.asp
  30. ↑ 30.0 30.1 30.2 http://www.sec.gov/answers/mfprospectustips.htm
  31. ↑ 31.0 31.1 https://personal.vanguard.com/us/investnow/si/newaccount?isFT=T&openAccount=T&PageLocation=TrustedAcctLogon&new=T
  32. ↑ 32.0 32.1 http://investor.gov/investing-basics/investment-products/mutual-funds#Buy%20and%20sell
  33. ↑ http://www.baronfunds.com/investing/how-to-redeem-shares/
  34. ↑ http://www.homesteadfunds.com/account-help/redeem-shares/
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