If you want to choose the best mutual funds, there are just a few simple things you need to know. After determining your investment goal (growth, income, or both) and your risk tolerance, you are ready to start building an investment portfolio. Fortunately, mutual funds have two main strengths: accessibility and simplicity. They are easy to buy and easy to understand.
Use a Good Fund Screening Tool
Before you start looking for the best mutual funds, you’ll need a good tool to help you with your research. There are many different mutual fund research sites that you can use to find the best funds. You can specify and select all the usual mutual fund selection criteria using Morningstar’s basic fund screening tool. This tool is free if you subscribe to the basic membership.
Use the Right Metric to Measure Performance
To choose the best mutual funds, you’ll need to know how to evaluate performance. Compare each fund’s historical returns against an appropriate benchmark, such as the average for funds in the same category or a specific index. For example, the performance of most large-cap U.S. equity funds is compared to the S&P 500 index.
You should keep in mind that mutual funds are typically used for long-term investment: more than three years. Place the greatest weight in your selection criteria on the five-year return. Also, look at the ten-year return if the fund has been around long enough. If the fund has outperformed the benchmark over five years, keep it in mind. If not, remove it from your search.
Check the Manager’s Tenure
Investors often overlook the manager’s tenure, which is the length of time the manager has overseen the fund. Look for a tenure of at least three years, and make sure the time period of the returns you are reviewing matches the same time frame the manager has been at the helm of the fund. If you find, for example, a fund with an outstanding five-year return, but the manager’s tenure is only one year, that means the current manager isn’t receiving any credit for four years of the fund’s previous performance.
Keep Fees and Expenses Low
Fees and expenses directly affect investment returns. This means that funds with lower fees and expenses tend to perform better over the long term than those with relatively higher expenses.
Note that the average expense ratio for equity funds in 2020 was 0.50%. Only consider mutual funds with low expense ratios. Avoid sales loads by purchasing no-load funds.
Look for Low Turnover
Turnover is a measure of the fund’s trading activity: how often the manager buys and sells the stocks or bonds in the fund. Turnover is often expressed as a percentage, called the turnover ratio. A low turnover ratio (20% to 30%), which is generally better for investors, indicates a buy-and-hold strategy and low trading costs. A high turnover ratio (over 100%) indicates a lot of buying and selling of securities, resulting in relatively higher trading costs.
Check the Number of Securities Held
By nature, mutual funds are diversified investments; they contain dozens or hundreds of stocks and/or bonds in a single portfolio. To ensure that the fund is diversified enough, you should look at the number of securities it holds at any given time. If the fund, for example, is invested in only 20 stocks, there is an increased risk of high volatility: sharp price fluctuations either up or down.
To ensure
Diversification and relative risk reduction, ensure that the fund has at least 50 securities before buying stocks.
Quick Tip on Index Funds
The previous tips apply more to actively managed mutual funds, meaning that the fund manager attempts to outperform the broad market return, as measured by an index like the S&P 500. However, in the long run, especially five years or more, the majority of actively managed funds do not outperform their index, which is why many investors prefer to buy shares of index funds instead. These funds aim to track, not exceed, the performance of their index. Since they are passively managed and require less work from their managers, their expenses should be lower than those of actively managed funds.
Disclaimer: The information on this site is provided for discussion purposes only and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.
Was this page helpful?
Thank you for your feedback!
Tell us why! Other
Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy and reliability of our content.
Investment Company Institute. “Trends in Expenses and Fees for Funds, 2020”, page 1.
S&P Dow Jones Indices. “SPIVA Data.”
Source: https://www.thebalancemoney.com/how-to-choose-the-best-mutual-funds-2466456
Leave a Reply