A well-diversified portfolio should consist of actively
managedinvestments as well as passive investments.
As StreetAuthority readers, you understand the importance of
carefully choosing individualstocks fordividend yield and outsize
Combining the personally passive aspect of professionally
managed mutual funds to your portfolio creates another layer
ofdiversification that can enhance the overall safety of your
principle, as well as enhance returns. Just like when choosing
individual stocks, specific guidelines exist for selecting the
mutual funds best suited for your portfolio.
There are more than 8,000 mutual funds being offered bybrokers
,advisors and banks. If you add in the differentshare classes of
thesefunds , it increases the choices to more than 25,000. All of
these funds are competing for yourinvestment dollar.
How can you be confident you're choosing the rightfund ? Here
are six basic rules to follow:
1. Focus Only On The Long Term
Mutual funds are created for long-term holding periods. Even the
top-performing funds have winning and losing streaks. Don't let
the short-term performance of amutual fund cloud your judgement
about whether the fund makes sense for you.
I take the Buffett philosophy to heart when it comes to
mutual-fund time frames. This means that the minimum time frame
I'll consider is five years when evaluating mutual-fund
2. Know Yourself
Understanding your goals and risk tolerances can help you choose
the right mutual fund.
Are you willing to sit through a large drawdown if the fund
has been proven to outperform over the longterm ? Do you prefer
smallergains but smaller losses to large gains and large losing
Everyone is different in this regard. Knowing yourself and
your goals can help you narrow down the mutual-fund choices.
3. NoSales Charge
Sales charges are also known as commissions or loads. Some funds
have front-end charges, which are like commissions when you
purchase the fund. Others charge redemption orback-end load fees
when you sell. If possible, try to avoid funds that charge these
types of fees.
4. Watch TheExpense Ratio
This represents the annual fees charged by the fund. These fees
can includeoperating expenses ,12b-1 distribution fees,
management fees, and administrative costs.
The average fees range from 0.20% of assets for index funds to
1.5% of assets for actively managed funds. Fees are a huge part
of the fund's overall performance.
In fact, history has shown that any fund that charges more
than 1% peryear will likelyunderperform the total returns of
anindex fund .
As you can see, fees and costs are critical components of a
fund's overall performance. Make certain the fees and costs are
not above the average.
5. Low Turnover
Turnover is the measurement of how long a mutual fund holds onto
the stocks it buys.
The longer a mutual fund holds on to stocks, the lower the
turnover. Turnover is synonymous withtransaction costs . This is
because every time the fund buys or sells astock , it pays
transaction fees such as commissions.
Turnover is generally measured on an annualbasis , therefore
funds with a 100% turnover completely change their holdings every
year. The average turnover for mutual funds is 80%, and index
funds average 5%. Try to find funds (other than index funds) with
turnover under the average of 80% for the best long-term
6. Risk-Adjusted Returns
It's not just the mutual fund's long-term returns you should
consider. The concept of risk-adjusted return needs to play
heavily in your analysis.
Stated simply, risk-adjusted return is a measurement of how
much risk is undertaken to achieve the percentage return.
The five principle risk measures arealpha ,beta ,
R-squared,standard deviation and theSharpe ratio . Each of these
measurements can be used to quantify the risk-adjusted return of
a mutual fund.
Risks to Consider:
Believe it or not, a majority of mutual funds do not beat the
indexes over time. Choosing your mutual-fund investments
carefully can helpput the odds of success on your side.
Action to Take -->
Services such as Morningstar and Kiplingeroffer mutual-fund
screening tools to help discover the right mutual fund for