Mutual Funds
How to Choose Winning Funds
The process is easy with these seven simple steps.
By Manuel Schiffres, Executive Editor, Kiplinger's Personal Finance
February 27, 2007
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Editor's note: This article is adapted from Kiplinger's Mutual Funds 2007 guide. Order your copy today.
With a mind-boggling array of mutual funds to choose from, it's no wonder millions of Americans throw up their hands and surrender management of their finances to brokers, financial planners and other advisers. That's a shame because you don't have to be a rocket scientist -- or hold an MBA -- to pick funds astutely. By investing in funds on your own, you can save a substantial amount of money because you won't pay sales commissions to a broker or a percentage of your assets to an adviser to do something you can do yourself.
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Although picking winners has some art to it, as well as science, it's easier if you approach fund selection rationally. Use the steps described below to pick funds like a pro.
1. Determine your objective. What are you trying to accomplish? For example, are you looking for maximum gains, and are you willing to accept the higher risks that come with lofty aspirations? If so, you might want a fund that buys shares of small companies or one that focuses on emerging markets, such as China and India. Or do you want steady income? That probably means you want a bond fund. If so, are you willing to settle for a fairly low yield to keep your risk down? Or are you willing to take on extra risk in search of high income? If the latter, consider a fund that invests in high-yield debt, also known as junk bonds.
2. Home in on a specific category. The fund world is a big place. It contains stock funds, bond funds, money-market funds and hybrids, which may own stocks, bonds, Treasury bills and sometimes even commodities. And there are a myriad of choices within each broad category. Some stock funds, for example, invest in big companies; others invest in small or medium-size companies. Funds that invest in rapidly growing companies with high-priced stocks are different from those that care less about a company's growth prospects and more about buying its stock at a bargain price.
There are similar divisions among bond funds, which typically are grouped by quality, maturity and types of bonds (municipal, corporate and mortgage, for example). See our list of our 25 favorite stock and bond funds.
3. Watch your costs. Fund fees can be confusing. To make matters as simple as possible, it's best to divide costs into two broad areas: fees you pay every year, and charges -- such as commissions -- that you incur when you buy or sell a fund. Most commissions go to the broker, financial planner or insurance agent who is advising you.
Annual fees, which are expressed in a figure known as the expense ratio, include management fees and legal, accounting and printing costs. They can also include ongoing commissions, which are called 12b-1 fees.
Here's a simple rule: If you invest on your own, buy no-load funds. A no-load fund does not charge a commission when you buy or sell, and it is not allowed to levy an annual 12b-1 fee greater than 0.25%. Among families that focus on no-load funds are Fidelity, Vanguard, T. Rowe Price, Dodge & Cox, Baron, CGM, Royce and Marsico.
Why get hung up on fees when plenty of funds with high fees have delivered good returns? We'll answer that question with another question: Why start investing with two strikes against you? If you pay a commission, you start the performance derby in the hole to the tune of the charge. And annual fees lower a fund's total return, whether it performs well or not. Because future performance is unknowable, it's best to avoid commissions and to invest in funds with below-average fees. (The average annual expense ratio for diversified U.S. stock funds is 1.44%; diversified foreign funds, 1.55%; domestic taxable bond funds, 1.09%; and national municipal bond funds, 1.02%.)
Vanguard, in particular, is known for its rock-bottom fees. Vanguard 500 Index fund, for example, sports an annual expense ratio of just 0.18%, meaning the fund extracts $1.80 per year in fees for every $1,000 you invest.