Choosing a mutual fund is tougher than deciding between a tall mocha and a grande decaf at the local coffee shop. Selecting the right fund demands a ton of research and a break from our insistence on immediate gratification.
With that in mind, here is a five-step checklist to help you winnow down your search and streamline the decision-making process. And remember, a good cup of coffee will get you through the morning, but a good mutual fund will get you through retirement.
1. Know What You Need
Before you buy any funds, you should review your portfolio to prevent overlap in overall asset allocation. Adding funds haphazardly is akin to betting on a hand of poker without first looking at your cards, and there is simply no need to weigh yourself down with too many funds.
"If you have more than five stock funds, you have too much," says Vicki Schultz, a Nevada-based financial adviser. "Large-cap, mid-cap, small-cap, and maybe two specialty funds like real estate and international are all you need, provided they are good ones."
Also, if you need to replace a poor-performing fund, then you should try not to dwell on short-term penalties associated with selling early. Rick Bloom, financial adviser at Bloom Asset Management in Michigan, says, "When a new client comes to me, I compare the funds in their existing portfolio to similar ones in their categories. If they are not better than the average fund in their category, then I get rid of it. It does not matter about taxes or fees -- you can't let a 2% penalty dictate the 98% left in the fund."
2. Performance Matters
Ask any financial adviser and they will tell you performance is most important. But there's more to performance than just beating any old index. You need to see how your fund stacks up against the right index.
New Mexico-based financial adviser Robert Rikoon says the fastest way to do that is to compare the fund against a similar exchange-traded fund, or ETF. For example, it makes little sense to compare a real estate fund against the
index. But measuring the fund's performance against the
iShares Cohen & Steers Realty Majors Index Fund
will enable you to see if the manager is beating his bogey.
Risk is another important item. A fund manager might have thoroughly beaten the index last year, but you need to know how much risk he took in doing it. Looking at a fund's beta is one way to do that. The higher a fund's beta, the more volatile it is relative to its benchmark. A beta that is greater than 1.0 means that the fund is more volatile than the benchmark index.
Daniel Buczak of Pacific Advisory Services says he looks for managers who beat their respective indices with the lowest beta possible. His favorite fund families along those lines are American Funds and First Eagle.
3. Keep an Eye on Costs
If a fund's risk-adjusted performance is good, then costs might not be too big a concern, especially since most fund-tracking companies measure a fund's performance after fees. But because nobody likes to pay too much for anything, most advisers suggest no-load funds with low expense ratios. And no matter what you hear, there are plenty of good ones out there.
Morningstar says its average stock fund expense ratio is about 1.5%. However, some fund families -- Vanguard stands out -- offer great performance at an annual cost of 1% or lower.
Of course, investors need to remember that small-cap funds and specialty funds that involve heavier research often have higher expense ratios.
Investors should also look for the lowest possible 12b-1 fees, which are marketing fees that have been widely criticized. Schultz steers clients toward funds with a 12b-1 fee of 0.25% of assets or less.
4. Turnover Can Hurt
In 2001, many investors suffered a double whammy. They lost money in their funds as the market plummeted, and were stuck with large tax bills due to their fund's tax inefficiency. The lesson is that even if your fund does not make money over the course of the year, you may still have to pay taxes on any gains your fund made when it sold existing holdings to combat market volatility.
The best way to combat tax inefficiency is to search for funds with low turnover. Turnover is a measure of trading activity during the previous year, expressed as a percentage of the average total assets of the fund. For example, a turnover rate of 25% means that the value of the stocks traded represents a quarter of the assets of the fund.
If a fund manager is an active trader, then you should consider putting that fund in a 401(k) or another type of tax-deferred account.
5. Monitor Manager Tenure
It's quick and easy to compare costs, performance and turnover. Those are quantitative guideposts. Judging the fund manager on a qualitative basis is harder, especially because few people ever actually meet the person handling their money.
Two facts that offer a bit of insight into a manager's nature are the length of his tenure with the fund and whether he has money invested in it -- facts that can be found in the fund's prospectus.
Schultz says, "I like little boutique firms where the managers have their own money in the fund alongside their investors. Having their name and money in the fund makes them more passionate."
Some investors might not like fund managers who hop around, but Bloom says that fund-hopping is more of a problem for smaller funds than big ones such as Fidelity and T. Rowe Price that boast very deep benches.
Of course, different advisers employ personal tests, too. Rikoon's final screen for fund managers? "I like gray hair on a manager," he says. "I have no use for young people who have made no mistakes."