How to Choose a Mutual Fund

Start With Your Goals

As is always the case with investing, choosing the right mutual fund starts with you.

"With so many choices, you need to develop a strategy that best helps to match you with a fund that will address your investment goals," says Todd Soltow, investment advisor and co-founder of Frontier Wealth Management.

Start by thinking about your goals for the money you're investing and how much time you have to reach those goals. This timeframe (or "investing horizon") will help determine how aggressive or conservative the fund should be.

While high risk doesn't always equal high reward, people do tend to think about investments in two ways: higher risk for higher reward, and lower risk for lower reward. Broadly speaking, stocks are considered both higher-risk and higher-reward because they can be volatile but, over the long term, deliver excellent results compared to many other investors. Bonds, on the other hand, are traditionally a slower, steadier investment that won't deliver nearly the same amount of upside as stocks, but they won't cause as much heartburn, either.

Go back to your investment horizon. Typically, the more time you have to reach your goal, the more aggressively you can invest. That's because you have more time to ride out market downturns and enjoy the higher long-term rewards of higher-risk asset classes. However, if you need the money in, say, the next few years, you should invest more conservatively to reduce the chances of your money rapidly disappearing in a market downturn.

Determine Your Risk Tolerance

The amount of risk you should take is also determined by your own feelings toward risk.

"Even if you have a long horizon to work with, you may be more conservative than your other younger counterparts and may want to lean to a more conservative fund or mix of funds so that you feel more comfortable with the ebbs and flows," says Kris Jerke, president of financial planning firm Ascend Financial.

He tells investors to ask themselves: "If I had $100,000 to start with and the value went down to $75,000 after a year, would I be comfortable with that and stick with it for the long term, or would I be tempted to sell and change things up?"

You can tweak the numbers to back into how much of a drop you're willing to tolerate in the short term. "This is important, as you want to make sure you're invested for the long haul and you need to be comfortable with your investments," Jerke says.

Even the best-performing mutual fund over the long term won't do you any good if you sell out of it every time the going gets rough. A good rule of thumb? Never invest more aggressively than necessary (or than your stomach can tolerate) for the return you need to reach your goals.

Consider Fund Types on a Risk-Return Scale

Once you know the risk-return level you're after, look for mutual funds that match this criteria.

"Each fund type has an associated risk level compared both to other fund types and similar funds in the same category," Frontier's Soltow says.

Consider large-cap mutual funds, which invest in big companies such as Apple (AAPL) and Amazon.com (AMZN). They are considered less risky than small-cap mutual funds, which typically invest in companies worth less than $2 billion, because their holdings generally have more diverse revenue streams and are less likely to go bankrupt, and thus their stocks are typically less volatile. However, smaller stocks generally have more growth potential (the saying goes that it's easier to double from $1 million in revenues than it is to double from $1 billion), so while the ride might not be as smooth, a small-cap mutual fund could deliver much better long-term returns.

But even within their own category, funds can have more or less risk than their peers. Mutual fund rating sites such as Morningstar rank funds rank funds on a risk spectrum relative to the average of their peers. That allows you to further tailor for risk – say, by selecting a more aggressive large-cap fund or a more conservative small-cap fund.

Think About the Fund's Role in Your Portfolio

Also consider how the investments you plan to own will play together in your portfolio.

As we mentioned before, mutual funds are a great way to diversify your portfolio. But there's more than one way to diversify. One is to hold many stocks or bonds so no single holding's individual performance can tank your portfolio. But in many cases, you also will want to hold different funds from different asset classes.

"This will help your performance to even out a bit more over time, as certain asset classes will perform better than others at different times due to market performance cycles," Ascend's Jerke says. "You'll want a mix of large-, mid- and small-cap, international funds and potentially some bond funds, depending on your age and time horizon." Again, the younger you are and the longer your time horizon, the more aggressive you probably can afford to be. That means you can lean more on stock investments as opposed to something more conservative, like bonds.

You can use mutual funds to fill each of the buckets Jerke mentions; if you have less money to start with, you might choose fewer buckets to fill. But as you have more money to invest, you can add more buckets, and you can eventually diversify further by delving into the investment objective of each fund. For example, some stock funds focus on value companies, while others focus on growth.

Just don't trust the fund name alone, Jerke warns. "Many times, you can tell by the name of the fund what the focus of it is and thus feel pretty good about where it's invested, but some funds aren't so clear."

One important practice is to look at each fund's top holdings and ensure there is little to no overlap in your portfolio. Too much overlap can lead to overconcentration – the opposite of diversification.

"You may choose five different funds, but when you dig into the holdings of the funds, find that they have a large number of common holdings," Jerke says. If this is the case, you might want to avoid a few of those funds and find other options.

Evaluate Fees

Mutual funds can charge several fees. The most common is annual expenses (often referred to as the "expense ratio"), which is the percentage of your money that goes toward covering the fund's costs rather than earning a return on your investment. Other costs include charges when you first invest (front-end sales loads), charges when you sell the fund (back-end sales loads), and annual marketing or distribution fees (12b-1 fees) that are charged on an ongoing basis.

Ultimately, any fee you pay eats into your return, so you want to minimize fees as much as possible. Choose no-load mutual funds (no sales loads), such as the members of the Kiplinger 25. Or if you want to buy a fund that has a sales load, do so through a broker that will waive this fee for you. Also avoid funds with 12b-1 fees when possible.

However, while it's important to pay attention to fees, Aaron Bock – manager of public market strategies and senior research analyst at financial planner The Colony Group – says you should consider fees in relation to the value you get from the fund. "A manager that has higher fees but also has a track record of long-term outperformance has been worth the extra cost," he says.

This leads to the next consideration when choosing a mutual fund: past performance.

Look Beyond Recent Performance

"Past performance isn't indicative of future returns." It's a true and well-worn statement, but it's also one of just a few data points investors have to evaluate a fund. The best thing you can do: Use it wisely.

"Investors are notorious for solely using backward-looking performance from a single point to select mutual funds, and as a result will often jump out of an underperformer into a relative outperformer only to have the tables turn," Bock says.

"Every mutual fund manager goes through periods of underperformance relative to their benchmark," he says. As such, you should use "multiple time periods, in addition to rolling returns, in order to assess how the manager has done in different market environments."

Bock adds that the manager's investment philosophy and process are more important than recent performance when choosing a mutual fund. Buying into mutual funds with managers who have a solid investment philosophy and long-term record of performance, but whose style is currently out of favor, is one of the best ways to find investment success, he says.

Look for managers that have "a robust, repeatable process" that is well-equipped to consistently outperform the fund's benchmark in a consistent manner, Bock says. This should help you find managers who are truly superior rather than just getting lucky in the current environment.

The caveat here is newer funds, which won't have a long-term track record for you to evaluate. If this is the case, Bock suggests looking at the manager's experience prior to joining the fund.

"The fund's portfolio manager could have a lengthy track record in a different vehicle such as a separately managed account," he says. "In addition, managers could potentially bring their processes and teams over from competing firms."

Consider Fund Size

One last metric to pay attention to when choosing mutual funds: total assets invested in the fund.

Generally speaking, smaller funds are riskier because, like smaller companies, they have a higher probability of being shut down. (Funds must reach a certain size to be profitable to their firm.) So, when choosing a mutual fund, you usually want to look for one with high assets under management – ideally $1 billion or more.

Again, it's a rule of thumb, but it's not written in stone. Even a manager who has a strong track record running a smaller fund might struggle once their fund grows. This typically happens when a fund becomes so large that its manager can no longer maintain its investment strategy. For instance, a small-cap fund might accumulate so much in assets that they're no longer able to invest in smaller companies without "moving the market," forcing them to target larger stocks they otherwise would've avoided.