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Picking the Right Mutual Funds

First, Define What You're Looking For

By Fred Yager
ConsumerAffairs.com

November 9, 2006

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Financial advisors will tell you that one of the best ways to start investing for the future is through mutual funds. They give you instant diversification, which means they are less risky than buying individual stocks and bonds and they come with a professional money manager who is supposed to know where to put your money to get the best return.

Sounds pretty simple, right? Well, it is until you actually set out to buy into one.

That's when you find out there are over 7,100 mutual funds to choose from. There used to be a lot more, but other nifty investment vehicles like Exchange Traded Funds (ETFs) and Hedge Funds have come on the market to steal some of the thunder.

That doesn't diminish the popularity or the benefits of mutual funds. The trick in this daunting circus is in knowing how to choose the best fund for you. And you can be sure that not all funds are created equal. Nor does one size fit all, which means a fund that would make sense for someone nearing retirement is probably not a good investment for someone in their 20s and just starting out.

Add to that the latest tracking report that shows 75 percent of those 7,100 funds actually under-performed the stock and bond markets and many of them lost money and you have your work cut out for you.

Today, with so many Americans with 401(k) and 403(b) retirement plans, more than 80 million people own mutual funds, which are simply investment vehicles that use money from a pool of investors to buy stocks or bonds or a combination of both. A mutual fund has a manager who usually follows an investment strategy that has a built-in risk factor.

How Much Risk?

So the first way to whittle down the choices is to decide your level of risk.

At the shallow safe low-risk end of the pool are money market funds, bond funds, and balanced funds. Medium risk investors should consider asset allocation funds, growth and income funds and index funds. And if you're ready to dive off the high board look into global or foreign funds, growth and aggressive-growth funds, and small-company growth funds.

Next, decide how soon you'll need to get your hands on your money. The shorter the time period, the more conservative or less risky your investment criterion should be. People in or near retirement would fall into this category. That's because they won't have time to recover from a steep drop in the market and those dips can happen at any time.

But if you're a good 20 to 30 years from retirement then go for high risk. Pick the most aggressive fund you can find because you'll have plenty of time to weather any steep market fluctuation or correction.

Third, you need to think about a fund's management fees and sales charges because they will affect how much you actually make from your investment.

If you buy your fund from a full service broker, chances are you'll pay a sales charge or "load." This can range from less than 3 percent to as much as 8.5 percent. Brokers will tell you how you make it up because these funds perform better. But that's not always true. In fact, studies have shown that "no load" or funds that do not have a sales charge, do just as well as load funds.

The difference is that you buy no-load funds directly from a fund company so you may not get the extra, at least partly personalized guidance a financial advisor or broker may have to offer. You have to decide if that extra advice is worth the added sales charge or not.

Even with a no-load fund, there are still costs involved. All funds have operating expenses, and they get passed right along to you and me.

What you have to do is check what's called the fund's "expense ratio." This will tell you how much the fund spent on expenses for every $100 in the fund. According to Morningstar, which tracks mutual funds performance, the average expense ratio cost for all funds was $1.35 for every $100 you invest. So you may want to stay away from those funds that charge more than that.

Performance Counts

Another factor to look at is the fund's past performance, but don't just consider the last three months or even the last year. Look at 5-, 10- and 15-year averages. This will tell you how a fund performed in both up and down markets.

Also make sure you're comparing it to other funds in its category. A small cap growth fund that returned a 12 percent gain over a five-year period may appear good, but when you find out small cap funds average at least 15 percent for that same period the fund that looked good before is actually a dog.

You also have to take a close look at the fund's manager. After all, that's who's going to decide where to put your money.

Find out if the same person who made the fund you chose a spectacular performer is still managing it? Check to see if the fund manager invests his or her own money in the same stocks or bonds that are in the fund.

Look for fund managers with a successful track record and that means at least five years of good performance in both bull and bear markets.

Moonlighting

Recently there has been a trend in which more and more fund managers are dividing their time between mutual funds and more sophisticated hedge funds. Morningstar found 124 mutual fund managers were simultaneously managing hedge funds.

This could pose a couple of conflicts.

Hedge funds pay their managers more than mutual funds, so there could be an incentive to spend more time and attention on hedge funds. Some hedge funds also use a "shorting" strategy which is where they win if the stock they're shorting falls in value.

The potential conflict occurs when a manager shorts a stock in the hedge fund while holding a "long position" in the same stock in the mutual fund. A long position is where you want the price of the stock to rise. Most fund managers who run a hedge and mutual fund simultaneously say they try to steer clear of those situations.

Finally, when it comes to picking a mutual fund, you should also be aware of certain tax considerations.

A fund that buys and sells a lot of stocks in a short period of time could generate capital gains taxes which you as a fund owner would have to pay. So you may want to look at funds that have a low turnover rate by buying and holding stocks for longer periods.

So don't be intimidated by having over 7,100 mutual funds from which to choose. Be confident in knowing that with so many funds available, there are undoubtedly seveeral that are right for you.

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