With hundreds of mutual funds available how is a beginner supposed to know how to choose a mutual fund?
What if I told you I could teach you some basics to look at to help you decide what the best mutual fund is for you?
Well, I am going to do that. This guide is to walk you through picking out your own mutual fund.
First off, what exactly is a mutual fund? It is an investment vehicle where a group of people pool their money. The manager then takes that money and buys whatever investment the fund is focused on.
Mutual funds are a great investment for beginners because you get instant diversification. Also it allows you extra time to learn more about the markets before you start making specific asset purchases.
How This Guide is Set Up
I will walk you through exactly how I would pick a mutual fund to invest in. I am beginning this as if this is my first investment so we don’t have to worry about asset allocation.
We can get to those as we learn more and have more money!
I am also starting this search as if we were investing on a monthly basis for under $100 each month. This way anyone can get going with their investing – cut out a pizza and an extra $25 can start working for you each month.
When I am researching the next fund that I want to invest in it takes me approximately 4 – 8 hours. Don’t let this scare you off though – the nice part about mutual funds is you only need to research them about once a year.
****If you are already overwhelmed, investing in index funds is a great way to get the market return without worrying about the quality of the manager.****
For the research part of looking for a mutual fund I prefer to use Morningstar. I like it because it is easy to use and you can save your searches so that you can continue do your research over time.
(I have been using them to research and check my portfolio since 2001).
They have both a paid option and a free option. The free version is not as detailed as the Premium version so it takes longer to go through all the funds.
There are a few other options if you prefer not to use Morningstar. Here are a couple I found to be easier to use.
Phase One: From 1,000's to 25
The first goal for is to get to a manageable number of funds that we can handle researching and still have a life.
This is the criteria that I started with:
1. The fund is older than 10 year. On the screener this will look like FundInception date is greater than today’s date 10 years ago. For example if today was January 4, 2011 then the screener would be: Fundinception <= 1/04/2001
2. Morningstar rating is a 5, 4 or 3. I choose this because it will take out the bottom of the funds. I don’t take Morningstar’s word for everything. But I can at least base my research off their top selections to help cut the number of funds. Also note they create their rating based on historical data, so it is a way to filter out the bad investments.
3. Fees and Expenses are less than 1% - I don’t like paying any fees as that reduces my return on the investment. Thus I try to find the best fund with the lowest fees. There are wonderful funds out there with low fees so there is no need to pay higher ones!
4. Closed to new investment. I make sure that option is equal to no, otherwise you are picking a fund that you cannot invest in. Funds close to new money if they feel they cannot invest the money in the right investments.
5. Minimum Purchase (for automatic investing) equal to or less than $100. Since we are going to be investing a smaller amount we want this number to be as low as possible. This is usually lower than the regular minimums required. (Note sometimes Morningstar does not have this information correct. So double check with the fund company before picking the fund.)
6. Category equals domestic stock. To begin investing I recommend starting with a basic growth fund with US stocks. This is a good core investment area for long term investors.
7. Role in Portfolio equals core. The two options are core and supporting. Supporting will give you specialty funds like bank only stocks. Core is a fund that covers many industries and has a general goal. To start our investing, we need to establish core funds before we begin to specialize. This is another safety measure to make sure we are diversified.
8. Fund Manager Tenure is equal to 2 years or more. I like to use this criterion as the results and direction of the fund are likely to follow the manager. You can see how the current manager has done compared to the market. It creates more consistency in what you are reviewing. You don’t have to worry about a new manager changing the course of the fund.
9. Trailing returns for 10 years is greater than the category average.
10. Trailing returns for 15 years is greater than the category average. I use this one and the one above to show that their long-term returns are better than their peers. And that thisis achieved on a consistent basis.
With these criteria, we have narrowed our list from thousands down to hopefully under 25 funds. Our next stop is to start to evaluate those funds one at a time.
Remember this isjust the criteria I like to choose. As we go through this we will learn more about all the options for searching. Learn about each and decide what is most important for you.
Phase Two: Detailed Research
Now that we have a reasonable number of choices to sort through we can begin to review each fund. The goal is to continue to cut funds that are not the right option.
To start with I looked at the following information for each fund. I used Morningstar and the fund companies’ website.
To find information on a company’s website, find the fund listing. Then download the prospectus.
- P/E (price to earnings ratio) – This will tell you how the stock is valued to its earnings. This is especially important in times of bubbles and general strong markets. I tend to look for funds under 20 in the 14 – 18 range.
- Tax exposure – this is especially important if the mutual fund is going to be held outside of a retirement account. This will help you get a feel for how much impact the fund will have on your taxes.
- Management – I like to ensure that the managers have been there for a while. I also like it better when there is more than one manager. In case something happens you have more than one person running the fund. This is not a complete deal breaker for me if everything else looks good.
- Returns – at this stage I am looking to see how they have done against the market and their peers. I am not looking at recent returns but for the life of the fund. Can theyconsistently perform or are they a one hit wonder?
- Portfolio information – here I am trying to get a feel for the fund and see if anything jumps out at me that I don’t like.
- Style box – make sure they match what you are looking for here. Many funds maybe categorized as one thing but in practice be investing in another style.
- Top 25 holdings – I have never nixed a fund because of this, but it gives me a feel for what the manager likes to invest in. Then I can decide if it is in line with what I like. It will also show you if there is a high concentration in one industry.
- Number of stocks in the fund – too few and it can be a riskier fund. Too many and you have to wonder how much the manager knows about what they are investing in. Additionally, you may not be getting any benefits beyond an index fund if there are lots of stocks.
- Foreign Stocks – many domestic funds are allowed a certain percentage that does not have to match the goal of the fund. This helps to know exactly what you are getting.
After reviewing these items for each fund, I decided that I needed to go back and adjust some of my initial criteria.
Take Away: Keep tweaking your search as you discover new things across all funds you can change.
I decided this because too many of the funds were like each other.
Following is how I adjusted the search.
- I added trailing returns for 5 years is greater than category average. I added this to ensure that even though they did great over the last 10 – 15 years that they still had a solid track record. I was beginning to see what used to be solid funds not having as great a return. I want my funds to be both good today and have a great track record from the long run. Don’t chase recent returns, chase good funds thatare proven over both short and the long run. (I did not add the 3-year option because there is too much volatility in the 3 year time frame. Everyone can hit a rough couple years, your stellar funds will get that back on track by the end of 5 years.
- Added that the “special fund type” was not a “fund of funds”. Fund of funds are mutual funds thatare made up of different types of mutual funds. I like to stay away from this as it tends to add more expenses. Plus I like more control over the entire portfolio. I would rather buy eachindividually. A fund of funds can broaden your exposure to different areas of the market. ButI believe this canbe accomplished through a good well diversified mutual fund plan. Especially when we are looking at equity growth funds and not a mixed set such as stocks and bonds.
Next round we will continue to narrow down our list and get more into what to look for.
Phase Three: Minimums & Open to New Investment
The next logical step in narrowing down our list is to make sure each fund fits our needs.
Two factors are the most important to look at. First, can I meet their monthly minimum investment requirements. Second, is the fund open for new investment.
If these two things are off, it does not matter how great the fund is. We won't be able to invest in it.
While we did sort for this already, this is one area that I find Morningstar sometimes does not have the right information.
I like to go to the company website to confirm this. On Morningstar go to the 'Purchase' tab. There you will find a link to the company website.
Click over to the site and search for the fund. You should either find the information in the prospectus or fund application. If you can't find it, call customer service. Ask what their minimums are for monthly investing.
If this meets your needs for investing, keep the fund on the list.
Open to New Investment
Next, we need to look further into the eligibility of the fund for investing.
This extra step in needed even though we already sorted by this because some funds have different classes of funds. All classes have different information.
Due to changes in the different classes, Morningstar does not always have the most accurate information.
To see if any of the remaining funds are a specific class of shares you have two options.
First you will be able to tell this by the addition off a letter after the fund name. For example, it might be Andrea’s Aggressive Growth A.
Second, go to the 'purchase' page. Scroll to the bottom to see if there is a list of different share classes.
If there is a class with the fund, go out to the company’s website to determine if the fund is still open.
I have run into situations where the class I am looking at is closed to new investors but all the other classes are open.
FYI - One of the main differences between classes has to do with fees and where you can buy it from.
A Bit About the Prospectus
This document can be very overwhelming for many reasons. The language is confusing and it is long. With time, it gets easier, but it does require you to read a few of them to get the idea.
There is now a summary prospectus, that is easier to read but it does not have all the information included. (Please don’t feel like you cannot invest if you have difficulty reading this document. I took a stock analysis class in college and during that class we learned how to read a prospectus. So please as your learning this remember it is actually part of a college class!)
Look in the prospectus to see the requirements for investing in the class that you are looking at purchasing. Doing this ensures that you are able to invest in the class you are looking at.
After I have confirmed that I can still invest in my remaining funds I begin to look at other components.
Phase Four: The Final Decision
We are finally at a point where we should be able to make a final decision on the best investment for us.
You should be down to only a small handful of options,hopefully under 10. If you are not under 10 continue to refine previous criteria to get down to 10. Much more than 10 and it will take too long to figure out the right one for you.
From here you begin looking at the details of each fund. I glance at the following:
- Dividend Yield – dividends are a large part of your investment return. All things being the same I pick the fund with the higher yield.
- Expenses – expenses eat your investment, the lower the better.
- How the fund has fared compared to the S&P 500? If they are not beating it then consider an index mutual fund or another fund.
- How the fund’s trailing return has done. How have they done the past 10 years? Is it getting worse, better or the same? Remember you cannot predict the future from the past, but you can at least get a feel for how they have done.
- I read the fund analysis from Morningstar (premium feature). This is like getting a second opinion from a doctor!
- The portfolio’s capitalization and value/growth data. I want to make sure theyare invested in the area that I want to invest in. I also look at the historical data to make sure that there is not style drift.
- World Regions – Another way to confirm what is in the portfolio of companies.
- R-Squared – This will tell you how close is it to the index. It will be on a scale of 0 to 1 (or 0 to 100%). The higher the number the more it follows the index.
- Alpha – this will tell you if it beat the index adjusted for risk. (Only use if R-squared is high) If this is positive we are good, if the R-squared is high and this is negative I drop the fund.
- Beta – how it moves in tandem with the index. (1 means it follows the market)
- Management – when looking at an active fund you are picking the manager you like.
Then based on these I begin eliminating funds that do not meet my criteria. Or if another one of the funds meets the criteria better.
Finally, once it is down to 3 to 5, I select the one’s that I want to invest in.
I realize that at this point is where it gets tough for new investors.
Mainly because you do not choose an investment based on one statistic. You base it on many intertwining pieces of information and on your needs for the investment.
Much of this information begins to form a better picture the more you know about each statistic. For example, if you are only using alpha you may be lead astray as alpha is only accurate if your R-squared is high.
So understanding these two numbers can help you drop funds if the risk does not measure up with the returns when compared to the market.
If you don’t feel like you have learned enough to make a decision now, I recommend two things:
- Continue to learn about all the moving parts of investing. As you learn more and more it will become easier and yes it will begin to make sense. (check out my class on Intro to the Stock Market)
- As you are learning you don’t want to not invest, so you should consider looking at an index fund. Index funds are a great way to get the market return without extra fees.
Once you have chosen your mutual fund, it is time to invest.
Look to see if it is available without charge from your brokerage and if so then buy it there. If it is not available without charge, then go to the company website and invest there.
Congratulations you are now investing!