Step 4: Evaluate the Funds

The fourth step is to evaluate the funds. To effectively evaluate a mutual fund, you must understand a number of characteristics that differ among funds. The following is a list of tips for evaluating mutual funds:

Compare funds with the same objectives: It makes no sense to compare funds with different objectives. Funds that are trying to accomplish different goals will have different return and risk characteristics. Make sure you are comparing funds with similar objectives.

Evaluate the fund’s long-term performance versus the long-term performance of its corresponding benchmark: The difference between the fund’s return and the benchmark’s return is known as the fund’s tracking error. Research the reasons a particular fund has done well. If the fund has performed well because it has made good security selections, this is a good sign; however, make sure the fund has not inflated its returns by buying outside of its asset class, such as a large-capitalization U.S. mutual fund buying securities from Mexico or Brazil. Try to determine whether the fund has a record of good performance over many years or if the fund has only performed well during a single year. Examine the history of returns during both up markets and down markets. If the fund has historically underperformed as compared with its benchmark and similar funds, avoid the fund. It is easier to spot funds that are performing badly than funds that are performing well.

Look at portfolio managers: How long has the manager been managing the fund? Was he or she managing the fund during periods of good performance? After a fund has performed well, good managers will sometimes leave a company to start their own mutual fund company, and new managers will be assigned to manage the fund. Look at how long the managers have been managing the fund. If they have not been managing the fund for very long, you may want to consider other funds.

Examine the size of the fund: How much has the fund grown or shrunk in the last month, quarter, or year? If a fund is shrinking, it generally sells its liquid assets first. After this liquidation, investors who still have investments in the fund are stuck with illiquid stocks, which cannot be sold or which must be sold at a substantial discount.

Research the fund’s history: How long has the fund existed? Has it changed its style? How did it perform under previous names and managers? Mutual fund companies sometimes rename a poorly performing fund and change the fund’s investment objectives to mask poor performance. Be on the lookout for these changes.

Identify the fund’s fee structure: Sometimes funds will add additional fees or impose back-end loads on investors to reduce the mutual fund company’s costs. One example of an additional fee is the 12-b1 fee, which is a marketing fee that is paid by shareholders to cover the cost of marketing the fund to other investors. Avoid funds that charge 12-b1 fees. Generally, I recommend purchasing only no-load mutual funds, or funds that do not charge a sales charge. Although you cannot control returns, you are able to control costs. Work on controlling what you can control.

Once you have selected a few funds you are interested in, read each fund’s prospectus carefully. The prospectus should explain the fund’s goals, the fund’s investment strategy, any investment limitations that the fund has (asset class constraints), any tax considerations that will be of importance to investors, the minimum account size, the investment and redemption process for buying and selling shares in the fund, fees that the investor is responsible for paying, and the fund’s annual turnover ratio. Turnover is particularly important as it is an indication of how tax-efficient the mutual fund is. Funds with high turnover ratios generally cause investors to pay more taxes than funds with low turnover ratios as each sell generates a taxable event for tax purposes.

You should also consider the portfolio manager’s past experience, the length of time the portfolio manager has been managing the fund, the fund’s performance history over the past ten years (or the performance history since the fund was created), and the services provided by the fund management company.

Consult other sources of information:There are many different sources of financial information that can help you choose a good mutual fund. Printed sources (many of which have online sources as well) include the Wall Street Journal, Morningstar Mutual Funds, Forbes, Business Week, Kiplinger’s Personal Finance, Smart Money, and Consumer Reports. A good electronic source is the Motley Fool website at www.fool.com.