How to Pick the Best Mutual Funds: 7 Tips For Beginners

At any given time, there are thousands of mutual funds available. So how do you choose the right one? Although it may seem complicated, it’s not as hard as you might think if you follow the right steps.

Through mutual funds, a group of investors can pool their money. An investment manager then selects investments that match the fund’s investment strategy. As a result, individual investors who buy shares in the fund actually invest in the assets selected by the fund manager. Therefore, it is important to find a mutual fund that meets your goals.

Below are seven tips to help you choose the right mutual fund for your needs.

1. Consider your risk tolerance and investment goals

Knowing your own risk tolerance is critical in determining the best investing strategy for you and which mutual funds suit your style. Your risk tolerance informs your overall portfolio, each investment you choose, and your asset allocation plan. Even though mutual funds are by nature less risky than individual securities, they still come with their own forms of risk, and you can still sustain losses.

Risk in mutual funds usually refers to the fluctuations in the price of a fund, as opposed to the dividend risk and market risk associated with stocks, or the default and interest-rate risk that comes with bonds. As risk increases, both price volatility and total return potential increase proportionately. On the other side, risk declines along with decreases in price volatility and total return.

Regardless of your risk tolerance level, you can achieve your investment goals with mutual funds—whether they’re categorized as growth, balanced, or income—as long as you keep your money invested over the long term. The shorter your investment horizon, the fewer options you have in the mutual fund market to achieve your end goals. 

Risk tolerance can be the most important element in determining mutual fund selections. Two investors with the exact same investment objectives and investment capital will enter into two dramatically different portfolio scenarios if they have different tolerances for risk.

2. Reading the Prospectus

Obtaining a prospectus should be as easy as calling the fund’s toll-free number. Examining a mutual fund’s prospectus will most likely not be the highlight of your week, however, even if returns are spectacularly high. A prospectus can be dense and wordy, even hard to decipher. The average investor’s information needs are not considered in the organization or the wording. 

Important information is in there somewhere, but it can be hard to find in the midst of the legal jargon. In this highly competitive market, however, some funds are actually trying to soften the legalese in which the fund’s prospectus is written. 

In fact, many now publish easy-to-read newsletters to supplement the information in the prospectus—or at least translate some of it. However you get it done, it’s to your advantage to read the prospectus with an eye for specific areas of importance.

The Fund’s Objective

The fund should have a clear statement of the objective. Is it aggressive growth? Current income? While it may be clear-cut in bond funds, a fund’s objective is not always as obvious when reading the prospectus of a stock fund. If the objective is unclear, the mutual fund manager has more leeway. 

It also means your intentions in choosing that particular fund may not be carried out. If the fund’s objective is not clear, you can seek out a fund that is more clearly defined, ask someone in the fund’s investment information department, or follow the old rule of thumb and do your homework. Look up the fund’s current holdings.

The Investment Risks

The mutual fund prospectus should discuss the level of risks the fund will take in conjunction with its objective. Stock funds should discuss the types of stocks they are buying. Are they talking about speculation? Are they telling you about the volatility of particular stocks? Look at the warnings they’re giving you. Are they telling you about the currency and political risks involved with their international holdings?

The prospectus should specify the risks associated with its portfolio. As an investor, you should be aware of investing and how those risks mesh with your risk tolerance. To make the best possible investment choices, it’s essential to understand how different investments perform under different economic scenarios. 

For example, aggressive growth stock funds typically perform best as the market is emerging from a long downward trend. On the other hand, Bond funds often do well during periods of slow growth, as interest rates fall and bond prices climb. 

By combining your knowledge with the information in the prospectus, you’ll be able to make better, and better-informed, investment choices.

Current Holdings

The fund should clearly lay out the percentage of holdings they are committed to in each asset group. The prospectus should state, for example, that the management is required to hold at least 70 percent in U.S. bonds, or 80 percent in common stocks, or no more than 20 percent in international investments. 

The breakdown and parameters of the fund give you an idea of where your money will be invested. Other types of investments, such as cash instruments, may also be included. A fee table should outline all the fees associated with that fund. Read them carefully, and make sure you are left with no surprises. Operating costs, loads, and any other fees should all be included.

Financial History

A prospectus will also give you the history of that mutual fund. The financial information should provide the per-share results for the life of the fund—or at least the past ten years if your fund has been around for a long time. You can use this to gauge the total return of the fund on an annual basis. 

You can also look at the year-end net asset values, the fund’s expense ratio, and any other information that will help you gauge how the fund has performed over time. You can check on dividend payments if it is an income fund, or see the types of holdings the fund has sold and purchased.

3. Check the Fee Schedule

Fees are important to consider since they can greatly affect your investment returns. There are some funds that charge front-end load fees, which are charged when you buy shares and others that charge back-end load fees, which are charged when you sell shares. Funds that do not charge load fees are called no-load funds.

Load fees are not the only fees. Expense ratios also draw a lot of attention. Annual fees are usually a percentage of the assets under management. In other words, if you invest $100 in a mutual fund with a 1 percent expense ratio, you’ll be charged a dollar per year. The advent of index funds and increased competition has led to an increase in low expense ratio mutual funds, as well as mutual funds with no expense ratio at all.

The Investment Company Institute reported that the average expense ratio for actively managed funds fell from 0.71 percent in 2020 to 0.68 percent in 2021. According to the same report, the average expense ratio for index funds is 0.06 percent. If you plug the 0.68 percent into a mutual fund fee calculator, you will find that it can cost tens of thousands in a lifetime.

4. Know the fund’s management style: active or passive?

The management style of mutual funds is another way in which they can differ. A comparison of active and passive funds reveals the biggest differences. The manager of actively managed funds buys and sells securities to beat an index, such as the S&P 500 or Russell 2000. In order to achieve a higher performance level, fund managers spend a considerable amount of time researching companies, the economy, and other factors.

Fund managers tend to charge high fees to compensate for their time as part of actively managed funds. Do those fees make sense? It may seem difficult to answer, but if you compare the fund’s past performance with the market, it can help. The volatility of the fund should also be considered along with its turnover.

5. Recognize the differences between types of funds

Although there are thousands of different mutual funds, there aren’t quite as many types of funds. In general, there are a few different types of mutual funds that are aligned with different investing goals and objectives. Examples include:

  • Large-cap funds. Typically, these funds invest in large, widely held companies with a market capitalization of at least $10 billion.
  • Small-cap funds. The funds typically invest in companies with market capitalizations between $300 million and $2 billion.
  • Value funds. Value funds invest in stocks that are perceived to be undervalued. These are often well-established companies that trade at a discount. The price-to-earnings or price-to-sales ratios of these companies may be low.
  • Growth funds. Growth funds invest primarily in companies that are rapidly growing, with the primary objective being capital appreciation. Price-to-earnings ratios for these stocks may be high, and they may have higher long-term capital appreciation potential.
  • Income funds. Regular income is paid by some funds. Dividends and interest can be obtained from dividend stocks and bond funds, for example.

Learn more about different types of mutual funds.

6. Research past performances and evaluate them

Judging the past performance of a fund can be trickier than it might seem by glancing at five- and ten-year returns. Sectors or industries that are in vogue during one period may not be during the next. One spectacular year of 90 percent growth followed by four years of 10 percent growth will average 26 percent growth per year. 

This average would not be a good indicator of how that fund is performing at the end of the fifth year when you are thinking about buying. Also, a sector that has not fared well over a stretch of time may be on the upswing due to new products, consumer needs, or public awareness (for example, socially responsible stocks). 

This won’t show up in past performances. The same holds true for large- and small-cap companies. A fund that invests in small companies will not see large returns when the trend leans toward the large corporations, as it did in the late 1990s. 

The best you can do is look at each measure of past performance, read up on future expectations, and try to make an informed decision. Remember this: long-term five- and ten-year returns are important, but they are only part of the larger picture.

A mutual fund’s past performance is less important than you might think. Sales materials—like ads, rankings, and ratings—almost always highlight just how well a fund has performed in the past. But studies show that future performance has no tie to the past. Last year’s top fund can easily become this year’s loser.

The long-term success of your mutual fund investments is partially dependent on several factors, including:

  • Each fund’s operating expenses, fees, and sales charges
  • Any taxes due based on the fund’s distributions
  • The size of the fund
  • The age of the fund
  • Any changes in fund management or operations
  • The fund’s volatility and risk profile

When selecting a fund family, it is often suggested that you look for one that has been around a while. The one exception concerns emerging industries, such as tech stocks, an area in which all of the newer fund families have been around for about the same length of time. The better-established fund families can show you ten-year returns, which you can compare against funds in other fund families. 

They can also give you an indication of how the fund has fared during the bear markets and how long it took them to recover. Naturally, some of this will depend on the fund manager, but you have a better chance of finding a fund manager with ten years of experience at the helm of a fund at an older, more established company. 

Look at the ten-year returns and see if the same fund manager was there over that time period. If you look at ten-year returns and see that the current manager has only been onboard for three years, those ten-year returns won’t mean as much. It’s like looking at the last ten years of a baseball team that only acquired its superstars in the past three years; management experience makes a big difference. 

Additionally, you should compare the mutual fund that interests you with other comparable funds. If the fund you like had a 10 percent return last year and other similar funds were also around 10 percent, then the fund is performing as expected. 

However, if the fund is bringing in 10 percent and comparable funds in the same category are bringing in 12 and 15 percent, you can do better without changing your goals or choosing a more (or less) risky fund. All you have to do is find another fund in the same category.

7. Using Diversification to Minimize Risk

Diversification is an investment portfolio is absolutely necessary to achieve a well-rounded investment strategy. The point of diversification is to hold enough distinct funds to achieve your objectives while minimizing your overall investment risk. Though a fund innately offers diversification, owning disproportionate amounts of single asset categories—even in fund form—still opens you up to a lot of risks.

Different fund types (growth stock, municipal bond, value stocks, balanced, etc.) provide different risk/return objectives. As the number of risk/return combinations in your portfolio increases, so does your overall diversification. Sounds good, but you need an action plan to help you really achieve this critical goal. These guidelines can help you hit the right diversification target:

  1. Set clear investment goals. Your time horizon, risk tolerance level, earnings needs, and portfolio size all matter when it comes to your investment strategy. When the funds you choose match your goals, your investment plan is more effective. 
  2. Opt for quality, not quantity. The important point here is how diverse your fund choices are and how well they fit your investment strategy, not how many funds you own. Don’t think of diversification as a challenge to buy as many funds as possible or you’ll end up with a portfolio that does not match your strategy. 
  3. Value fund category above fund style. A fund category defines its objectives; the fund’s style is the method used to pursue those objectives.
  4. Avoid duplication. It is a waste of your investment monies to own multiple funds with identical objectives. It’s best to own just one fund in any particular fund category. 
  5. Fewer is better. When it comes to mutual funds, less is more. Use as few funds as you can to achieve the diversification you desire. Since most mutual funds hold between fifty and 150 individual securities, you can meet your diversification objectives with a small number of funds.

No matter how many funds you hold in your portfolio, the key to real diversification is to make sure that each fund contributes a unique means to secure your investment goals.

Final Words

Once you finally make a decision, expect to be in the fund for at least one year, usually five or more. Mutual funds are not generally thought of as a short-term investment, but sometimes market conditions can dictate change earlier than you had planned. 

If you’ve invested in a fund that was on the upswing and now it’s heading back down (or “correcting”), you may be better off selling before share prices drop lower. You’ll almost always have the opportunity to revisit the fund after it stabilizes, when you’ll have a chance to benefit from the next round of growth.

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