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When it comes to investing, mutual funds are a basic building block. About 44% of U.S. households and 94 million individual investors own mutual funds, according to a 2017 study from the Investment Company Institute (ICI). And they like them — more than 8 in 10 mutual fund-owning households believe mutual funds can help them reach their financial goals.
That said, knowing how to choose mutual funds isn’t always a slam dunk. There are some things you should understand before diving in.
How mutual funds work
A mutual fund is essentially a group of investments that have been put together to achieve a desired kind of return. When you buy a share of a mutual fund, you are buying a small piece of all the investments, so mutual funds are a useful way to diversify without needing to choose (and buy) individual stocks, bonds or other types of securities.
Mutual funds come in a variety of flavors, from those that track an industry, such as health care or energy, to those that track an index, such as the S&P 500 or the Dow Jones Industrial Average. Some are designed with your target retirement date in mind — getting more conservative as you get closer to quitting work. Others invest entirely in large or small companies, fixed-income and even international stocks. As of 2017, there were 9,356 mutual funds in the United States, according to the ICI — so it’s a wide field.
How to choose mutual funds
There are many strategies you can use to select mutual funds for your own portfolio. Knowing these seven key considerations will help you determine the right types of funds to meet your investing goals.
1. Define your purpose
First and foremost, what do you plan to do with the money you’re investing? Is it for retirement? College? A down payment on a house?
Answering this question will help inform the types of mutual funds you would consider. For instance, if you’re saving money for a down payment for a home, you probably wouldn’t invest it in a target-date retirement fund.
2. Assess your risk tolerance
How do you feel about losing money? How do you feel about losing a lot of money? “Everybody likes to make money, but what happens if, out of nowhere, it just gets ugly?” asked Peter Creedon, a financial planner with Crystal Brook Advisors in Mount Sinai, N.Y.
Whether you’re a younger investor with a lot of time to be aggressive or an investor nearing retirement who needs to be more conservative, there are mutual funds to match both approaches — and plenty in the middle. Try this risk tolerance assessment from the University of Missouri to get a better read on where you stand.
3. Examine the costs involved
Some mutual funds carry a sales load, meaning you must pay a fee to purchase or redeem them. Experts recommend steering toward no-load funds, which are mutual funds without those types of fees, instead. The less you pay on the front end, the more you’ll have available to invest overall. “No-load funds are plentiful, and there are many high-quality options,” said Kristi Sullivan, a financial planner at Sullivan Financial Planning in Denver, Colo.
You also should take note of the expense ratio on a fund, which represents the annual operating costs of running the fund. The lower the expense ratio, the more you’ll take away in earnings.
“If you own a fund where the gross return was 10% during the year and the expense ratio was 2%, then you are only netting 8%,” said Ted Toal, a financial planner with RCS Financial Planning in Annapolis, Md. “And studies have shown that funds with lower expense ratios tend to have better performance over time than funds with higher expenses.”
4. Look at the turnover ratio
Turnover ratio is a measure of how frequently the investments within a mutual fund are bought and sold each year. The higher the ratio, the more often that’s happening. If you’re investing within a tax-deferred account — such as a 401(k) or IRA — this measure doesn’t matter, but if you’re investing within a brokerage account, funds with high turnover can bump up your tax bill.
In either case, high turnover can boost transaction costs. “Anytime a fund makes a trade, they have to pay commissions on that trade,” Toal said. “The more they trade, the higher the trading costs for the fund, and that subtracts from the return of the investor.”
5. Weigh active vs. passive management
An actively managed fund means there’s a fund manager who is actively buying and selling securities based on what they think is best and aiming to outperform the market. Passive management, on the other hand, means a fund is automatically pegged to a benchmark or index, such as the S&P 500.
While it might seem like you’d want someone working for the best result, actively managed funds tend to come with higher fees, and the majority lag behind the market over time, according to research from S&P Global. Passively managed funds, meanwhile, mirror market returns and generally carry lower expense ratios — a win-win.
6. Don’t put much stock in past performance
Sure, you can look at how a fund has done in the past, but don’t make your decision based solely on track record. “Good past performance could be luck or a skill set that was trending at the right time at the right place,” said Mitchell Kraus, a financial planner at Capital Intelligence Associates in Santa Monica, Calif. “It’s very easy to create a portfolio or find funds that have great past performance. The trick is finding funds that will perform well moving into the future.”
If you’re determined to use track record as a metric, compare a mutual fund’s history to that of its peers. “Too many clients will see a fund that went up and buy into it, and most of that return was based on being in an asset category that had done well,” Kraus said. “There are funds that underperformed the market as a whole but have overperformed their peers in their asset category, and those are the funds that are important to look for moving forward.”
7. Make sure you’re diversified
While it’s acceptable to own funds with a very specific focus — technology stocks, for instance, or high-yield bonds — it’s not wise to put all your money into a single area of the market.
“You can make as many guesses as you want, but we simply don’t know what is going to perform well in any upcoming year and what’s going to perform poorly,” Toal said. “It’s best to generally own everything so you don’t have to guess. In the long run, you should come out with the average return of the market.”
Mutual fund investing can be a little overwhelming. There are thousands of funds available, you’ve got limited time to research them, and everyone has an opinion about where you should put your money. But if you have done your due diligence, are investing regularly and are diversified, you probably will be in good shape. Just stick with your plan.
“With all the information available today, it’s easy to get distracted and think there’s something better out there,” Toal said. “What most people will find is by constantly moving your money, usually you’re going to earn much less over time than if you just pick a good fund, stick with it and keep putting money into it.”