Choosing a Mutual Fund

There are thousands of mutual funds to choose from, with different investment styles, risk factors, and expenses. How do you choose the one that's right for you? There's no one size fits all with investing, that's why we have so many choices. Choosing a mutual fund is similar to buying a vehicle; you need to know what your vehicle should be able to do for you and what you're using it for, and you research until you find the one that suits your needs and your bank account. Consider these points as you narrow down your choices.

Your investment goal and how long you have before you need to cash in plays a big part in what type of fund may work for you. If you need the cash in less than five years, it is safer to invest in a money market fund or a bond fund to preserve capital and take less of a risk. If your financial goal is more than ten years away, you probably have time to ride out the highs and lows of the stock market, and a stock fund can bring better returns over the long term.

Your investment style and your comfort level with taking risk, as well as your age and how much time you have left in the workforce are factors to consider when looking for a fund that may be appropriate for your needs. All investments carry a risk of loss, some more than others. The less risky funds bring lower rewards, and higher returns come with more risk. Some funds are inherently more risky, such as sector funds or international funds. Funds that invest in large-cap companies are less volatile than funds that invest in smaller, emerging companies.

Asset allocation simply means spreading your money around different types of investments to reduce the risk of loss. What other investments do you already have? Do you have money in stocks, bonds, real estate, as well as cash in CDs or the money market for immediate needs and emergencies? What type of mutual fund will help you round out your portfolio? If you only have money invested in stocks or stock funds, you may want to invest in a bond fund to balance it out. If you are new to investing and are looking for your first mutual fund, a balanced or asset allocation fund can give you a well-rounded portfolio in just the one fund.

A mutual fund's expenses eat into your profits; funds with lower expenses automatically earn more when you consider what you're saving over a higher expense fund. A loaded fund with 12b-1 fees would have to outperform a no-load fund by several percentage points just to return the same earnings. Sales commissions have no bearing on a fund's performance, so sticking with no-load funds is the smart way to go. You should also take the fund's expense ratio into consideration; an expense ratio of about 1.5% is common for an actively managed fund, but a passively managed index fund can have an expense ratio of as little as .3%.

A high turnover rate can eat into your profits in two ways. Highly managed funds that do a lot of stock trading increase the expense ratio; the funds have to pay trading fees just like the individual investor does. On top of that, if there are profits when the fund sells the stock, you will have to pay capital gains tax even if the gains are automatically reinvested into the fund, and even if the fund itself actually loses. A turnover rate of 100% basically means the fund is trading out for a whole new set of companies in a year's time. It's best to look for funds that have a turnover rate of no more than 50%, and less than that is even better.

Mutual funds often have a minimum investment requirement, and they can charge a maintenance fee if your balance later falls below that amount. The minimum may be a thousand or a hundred thousand dollars, depending on the fund. To encourage you to save for your future, some funds have a lower minimum for retirement accounts if you have an automatic monthly investment withdrawn from your checking account. These minimum investment requirements may make some funds unavailable to those who are just starting out and have limited investment capital. A good option is to put your money in a money market account until you have saved enough to invest in the mutual fund you want, leaving three to six month's living expenses in the money market for an emergency fund.

Past performance is no guarantee of future performance, but comparing a fund to the benchmark index and other funds in its class can help you eliminate one that can't keep up with the others. Look at the fund's performance of at least a few years, in good and bad markets. The fund's Morningstar rating is based on past performance and risk, and funds are given a rating of one to five stars. Generally, four and five star funds are considered to be quality funds, but it's not a guarantee that the fund will continue to perform well, and a fund with a lower rating may start doing well and get a better rating next time. The Morningstar rating can guide you but it should not make your decision for you; a five star fund that doesn't suit your investment style and objectives is possibly worse than a three star fund that rounds out your portfolio perfectly.

Source: U.S. Securities and Exchange Commission