Mutual funds are essentially large pots of money. When you add money to a "pot" you own become an owner of a share of the "pot." A fund manager (with a management team) invests that money in various ways. They buy stocks, corporate and government bonds, and other financial instruments. As the value of those investments increase, the value of your share of the pot increases. If the value of the investments declines, the value of your share of the pot also declines.
Your goal, of course, is to invest your money in a mutual fund you believe will increase in value.
To make a wise choice about which mutual funds you will invest in, there are a number of factors you should consider. Here are some things to consider:
- Historic Performance
Most people who buy mutual funds are not interested in "day trading." That is, they are not interested in buying a mutual fund today and selling it tomorrow. Rather, they want to invest in a fund that they can keep for at least a year.
Perhaps you plan to review your portfolio of funds on a quarterly or an annual basis. As you evaluate the funds you hold you may choose to switch the two or three lowest performing funds for funds to funds that are performing better.
Examining the 1, 3, 5, and 10 year average rate of return for a number of funds can give you a good idea of how each fund may perform in the coming year. This is no guarantee, of course, but it is better than throwing a dart at the list of funds in your Sunday paper.
- Changes in Market Conditions
Market conditions can mean many things. There are "bull" markets that take place as the economy expands and many companies are increase their profits. There are "bear" markets when the economy is contracting and many companies are cutting back, more people are unemployed, and profits are declining.
Market conditions also take into account changes is a particular sector. The energy sector comprises those companies that help develop, transport, process, and deliver various types of energy. As large countries such as China and India become more industrialized their people will be able to afford more energy intensive products. Think of the effects on petroleum resources and gasoline prices caused by an additional billion people in China and India driving automobiles.
The pharmaceutical sector will undergo sweeping changes in the coming years. You already see the effects of the burgeoning population of elderly in the building of new drug stores. As the "baby boomers" start retiring their needs for drugs will increase.
Funds that react well to predicted market conditions can produce very good rates of returns when those conditions materialize.
- Size of a Fund
Managers of small funds can often be more agile in taking advantage of changes in the market. Small funds own fewer shares in each company than large funds. Because of this, they can buy and sell shares more quickly.
Large funds, owning huge numbers of shares of companies, cannot quickly "dump" their shares if a company's share price is dropping. Nor can large funds purchase a significant number of shares when a company's share prices appears to be moving up.
- Watch for Changes in Fund Management
The fund manager is responsible for setting the buy, hold, and sell philosophy for the fund. Many decision about when to buy and when to sell shares for a fund are easy. But, many decisions are often based on personal choices.
The fund manager whose philosophy helped make a fund perform well over a period of time is eventually going to leave that fund. A new fund manager, often someone who worked under the previous fund manager, will take over.
The new manager may have their own way of deciding when and what shares to trade. This can often produce changes in the fund's performance.
If a fund manager with good performance moves from one fund to another, you may want to shift your holdings out of the old fund to the new fund.
- Load or No-Load Funds
Mutual funds are divided into "load" and "no load" funds.
Loaded mutual funds are simply mutual funds that charge you a certain percentage of the amount of money you invest. This money is not invested for you. Rather, it normally goes to pay commissions on the sales agents who sold you the fund. This "load" is often referred to as a "sales load."
A fund with a "front end load" assesses the commission when you invest. A fund with a "back end load" assesses the commission when you sell.
Funds that carry no "load" have no sales commission. You may or may not pay your broker a commission for purchasing a fund. This often depends on the family of funds your agent works with.
The performance of "load" and "no load" funds in no way depends on whether a sales commission (or load) is charged. Most people believe that there is absolutely no reason to purchase a loaded fund.
- Managed or Unmanaged Funds
A managed fund is one for which a fund manager (and management team) decide which stocks, bonds or other financial instruments to buy, sell, or hold. While the management team has a lot of latitude in their decision making, each mutual fund has certain guidelines that constrain the management team.
Some managed funds specialize in foreign investments. Some specialize in certain sectors like energy or precious metals. Other funds invest in growth stocks. It's these goals that somewhat limit the management team's ability to buy and sell stocks.
A managed fund may sell stocks in one company to buy stocks in another company. Managed funds can switch a large percents of their holdings in any given year.
Unmanaged funds attempt to mirror certain financial averages. You are probably familiar with averages such as the Dow Jones Industrials, or the Standard and Poors 1500 index. There are many such indexes that try to reflect the market in general or certain sectors of the market. A fund that mirrors one of these indexes contains the stocks or bonds of that index in a proportion that reflects the index.
The only "management" that occurs in an unmanaged fund is the purchase or sale of sufficient numbers of shares to maintain the fund's reflection of the index it mirrors. The fund does not switch from one company to another to try to gain an advantage.
Because managed funds buy and sell much more than unmanaged funds, they include a larger sales charge. The managed funds may have a sales charge for 3% to 6% of their holdings in any year. The unmanaged funds buy and sell only to reflect the amount of money invested in the fund. Their sales charges are often around 1% of their holdings.
Because the managed funds have larger sales charges, they must make around 4% more than the unmanaged funds just to break even. That's why often 80% of the managed mutual fund's rates of return do not measure up to some of the unmanaged funds.
- Resources
Morningstar Fund Selector
Money Magazine Quotes and Morningstar data
Picking Top Mutual Funds
