Maybe, after months of research and so many questions, you’ve finally decided to put your hard-earned money into a mutual fund. Well, you may find this as a shock but you’ve just passed the easy stage – the harder part is yet to come. Now you have to choose the best mutual fund for your need and situation. But, how exactly do you do that?
According to statista, there were 9,511 mutual funds in the United States in 2016 which manage some 16.34 trillion U.S. dollar in assets. If you are a first-time investor with minimal knowledge of mutual funds, you could lose your way by just looking at their different categories.
There are domestic or world equity funds that are further classified as either managed or indexed, domestic or world bond funds, alternative funds, and money market funds. Then, you can go by way of diversified funds such as balanced or hybrid funds that include target date funds.
Mutual Fund Investment: Things To Consider
A word of advice: do not jump in without fully understanding how it fits into your personal financial goals and situation. Many newcomers make this crucial mistake and end up losing financially. Remember this: it’s not about investing into the ‘best fund’ touted in the market but investing in the best one that serves your needs according to your financial goals, retirement plan, and your risk tolerance.
The good news is, we have provided some key points that you should consider as a novice mutual fund investor before letting go of your money.
Focus on Your Financial Objectives
First things first: identify and focus on your financial objectives. People have different reasons, needs and motivations to invest in Mutual Funds. However, as each person’s needs and profile are different, it’s not always a one-size-fits-all thing. So, you must select carefully – choose a mutual fund that will best address your need.
For example, if you are still young and have a long way to go, it is wiser to invest largely in equity growth fund rather than debt funds. If you are a retiree, debt funds would be a better option because they would provide quick, regular, and sustainable income.
If you are investing for a short period – like maybe you have some excess funds at the moment – ultra short-term funds are advisable. Focusing on your needs would help you narrow down your options.
Set Your Level Of Risk
After you’ve made up your mind to invest in equity mutual funds, it’s now time to do a little financial soul-searching. Define explicitly how much risk you can tolerate.
To say it simply, determine if you consider yourself conservative, moderately conservative, or aggressive when it comes to investing. By knowing that simple fact, you come closer to deciding what kind of mutual fund scheme you would be comfortable with.
- a) For the conservative investor, it’s better to invest solely in equity-oriented balanced schemes or large cap mutual fund schemes.
- b) For the moderate investor, it’s appropriate to go for large cap and multi cap schemes (or diversified equity).
- c) For the aggressive investor, it’s often the mid cap and small cap schemes. Some would add sectoral schemes to their list but only if you have a sound knowledge about how these sectors behave and operate.
A large number of investors use a combination of schemes to create their mutual fund portfolio. They often go through the whole range by investing in large, mid and small cap schemes to build up their own mutual fund investment package.
Evaluate Fund Performance
Even seasoned investors and financial advisors would testify that judging mutual funds based on performance is quite complex. It’s almost traditional to look at past performance when trying to choose a mutual fund but there’s a catch.
Past performance does not mean it will perform the same now or in the future. Statistically, there is no strong indicator that good-performing funds will continue to perform well or even better. In fact, many top performing funds do not remain on top or near the top for a very long time. Conversely, many poorly performing funds do improve while others continue to labor.
Using other tools would help you in making your selection. For example, you can use a Morningstar rating or check out the long-term performance of a fund to filter your field of choices. With this tool, you can skip the funds with a long track record of poor performances or those that may be at risk of closing or merging with other funds. Watch out too for funds whose performance swing excessively because they are far riskier than most funds.
How To Measure Performance
While reliance on past performance is very tricky, measuring performance is a simple science. They basically measure the average annual return of the fund – nothing more, nothing less.
It would be good to know that the Morningstar rating is quite elaborate. Morningstar gives a rating to a fund only after at least 3 years of existence. On top of this, their rating system considers factors such as account loads, sales fees, and redemption fees. They also rewind at the risk-adjusted performance of a fund using 3, 5 or 10-year periods and measure the results across these time periods depending on the term of the fund. The rating system also counterbalances costs and consistency of performance.
So, if they give a higher rating to a fund, this indicates that the performance has been more consistent. In case the fund shows a bigger swing in performance in relation to their peers, their rating will, in effect, get a penalty of sorts. The rating will suffer more if these swings are more on the losing side.
Professional Management Team
Finding a reputable portfolio manager is easier than you think. In fact, in this day and age, it has been more untroublesome to get the information you want and need on certain individuals, groups, and entities – including professional fund managers. Should you find a mutual fund manager with a very sparse or no track record, or, even worse, a card full of losses during the good seasons of the stock market, avoid them like a plague.
Ideally, you want a firm that has been established by one or more credible investment analysts or portfolio managers. It should be one that has a team of talented, skilled, experienced, and disciplined individuals who oversee the day-to-day responsibilities, and who has systematically handed down their values and expertise.
Lastly, it is a good sign if the managers have a substantial portion of their own investments or net worth are in the fund together with the fund holders. It’s easy to sweet talk but much more difficult to ‘walk the talk’. In this case, seeing them have their own capital at risk alongside yours is a powerful testament to their integrity.
Consider The Expense Ratio
One rookie mistake in choosing a mutual fund is neglecting to pay attention to the impact of fees on total returns – or which experts call the expense ratio. The fees vary from fund to fund and company to company. They also differ whether you choose a passive fund or an actively-managed fund.
A passive fund is one that approximates the growth of an index such as Standard & Poor’s 500 Index of Large Companies (there are many index funds you can invest in). An actively-managed fund is one that aggressively targets market-beating performance and is normally more expensive.
Don’t be fooled into thinking that compared to other fees like those of credit cards, your mutual fund fees (as a percentage of total investments) are low. What you might not realize is this: the fees that you will pay can eat up to your total returns in the long run.
Take a look at this: Say you have $50,000 in a fund that delivered a 5% annual return. Offhand, after 30 years, you’d probably be very satisfied. However, if you look at the fund’s expense ratio, you might become mortified instead of happy.
Expense ratio At 0.25% At 0.5% At 1%
Total fund expenses $14,914 $28,831 $53,927
If you want to avoid paying hefty fees on your mutual fund, you can invest in passive funds because they generally charge lower fees. Many of them tend to produce better returns so they are most appealing to many investors.
Digging deeper, you can surmise a lot by looking at a fund’s expense ratio.
You can get a very good inkling of what kind of company manages the fund by looking at the expense ratio.
It could be a greedy financial-services firm whose main agenda is to earn from you by dangling whatever is trending in the market at the moment. Or, it could be a company that is seriously willing to help you achieve your financial objectives through a long-term partnership. The latter kind will normally charge fewer fees.
For what it’s worth, the way a fund company treats its customers reflects its culture of dealing with their own employees. Fund managers can always leave their companies at any time – regardless of whether their portfolios have matured or not.
So, if they receive some ill treatment from their employer, they can quickly leave the company and go to another investment firm. This puts you at a disadvantage because unlike the fund managers, you can’t just withdraw your money and transfer it to another company.
Understand Your Cost
You might brush it off as insignificant but costs do matter when it comes to investments. First, you might want to take a look at this thing they call transaction fee or ‘load’. If the fund company is going to charge you an amount every time you transact with them, take it off your list of possible choices.
What it does is that it lessens your initial investment in the fund and the result of that simple reduction can be enduring. But watch out: some companies ‘hide’ their transaction fees in other ongoing fees so it pays to compare costs in total when evaluating your options.
Lower Risk By Diversification
Diversification should naturally happen when you invest in a mutual fund. By practice, fund managers spread their investments across different asset classes, equities, industries, sectors, and sometimes, even locations.
Diversifying lowers the risks particularly when compared with a portfolio that managers heavily invested towards a particular stock, asset class or industry sector.
It’s quite easy to check the portfolio history of a particular fund specifically to see if the fund consistently maintains a diversified portfolio. Simply look at the monthly portfolio of a particular scheme through the website of a fund company. You can also go to the websites of Morningstar or Kiplinger to check the portfolio details of mutual funds.
When it comes to money, there is always a risk. So, when we talk about investments, it does not make a difference whether you’re investing in equities or bonds or mutual funds – they are all exposed to market risks. And just because you cannot totally eliminate them, you should not look the other way.
Instead, find ways to contain these risks as much as you possibly can. The parameters and guidelines for selecting the best mutual fund for you can help tremendously to meet this objective.