Investing in mutual funds is one of the smartest strategies that small investors can use to grow their capital. Because mutual funds are actually a bundle of stocks, they offer the potential for steady growth while reducing the risk that comes with owning individual stocks. Additionally, mutual funds are run by professional investment managers who have staff, research and technology available that small investors often do not.
But that doesn’t mean that investing in mutual funds is a no-brainer. Professional management doesn’t come for free. When selecting a fund investors need to consider fees, taxes, fund manager experience and a host of other factors.
Socially responsible investors who want a fund that reflects their values can find more than 200 to choose from today. But those funds also should be judged by the same standards as other funds in terms of cost and risk, in addition to the personal values the investor holds.
Here are the ways to evaluate mutual funds. The information can generally be fund in the fund’s prospectus or on the company’s web site.
Fees and expenses. Mutual fund companies charge investors fees and expenses for the service of buying and selling stocks for their fund. It extremely important that investors be aware of those costs because over time they cut into the return on the investment. A fund that has high fees needs to have greater growth than a fund with lower fees to be competitive. Consider that $10,000 placed in a fund that generated a 10 percent annual return before expenses and had yearly operating expenses of 1.5 percent, would be worth $49,725 after 20 years. But if the fund had expenses of only 0.5 percent, then it would be worth $60,858 over the same period.
Taxes. Funds make an annual capital gains distribution to fund holders if it sells a stock for a profit that isn’t offset by a loss. Fund holders generally must pay a capital gains tax on that distribution. That assessment should be included in a calculation for a fund’s annual return. To guard against the impact, investors should contact to find out when the distribution will be paid out. The reason is to avoid buying in to a fund shortly before the payout is made and being assessed as if the investor had been a fund holder for the entire year.
Fund Performance. “Past performance does not guarantee future results.” It’s a standard disclaimer that mutual funds run when touting their how well they’ve done. Still, it doesn’t stop fund companies from running ads in national business magazines when one of their funds has had an exceptional year or receives a four- or five-star rating from Morningstar. Nor does it prevent many investors from being dazzled when they see the gains. Look at a couple of guides when evaluating performance:
- Time period. New funds sometimes burst out of the gate and post some market-beating numbers. But there could be some unique reasons for that. It could be in a hot sector that is about to cool off. The longer a fund has been in business, the longer its record and the more confidence it provides to investors.
- Fund management. A fund might have a sparkling 10 or 5 year average, but the most couple of years were dismal. An aberration? Perhaps. But check to see if a change has been made in fund managers. The manager who built the sterling record may have moved on and a new stock picker is posting poor numbers.
- Compare apples to apples. While it might be impressive that the XYZ Health Care Fund outperformed the S&P over five years, the true measure is how it performed against other health care funds. Investment sites such as Morningstar and Smartmoney allow you to compare the fund vs. sector benchmarks. If XYZ lagged the category even while beating the S&P, it might not be the fund to pick.
Risk vs. Reward. Investors can get a general sense of a fund’s volatility by looking at its history. Wide swings from year-to-year suggest it could be a risk for certain investors. Those who might need to recover their money in the near term for some financial goal should consider a fund with a less volatile history. Some sectors, such as technology and financial services, can be more volatile than others, such as health care. Funds that focus on those sectors would be naturally more volatile. It’s an important consideration for investors assembling a portfolio.