Don't Invest In Mutual Funds Without Reading This First

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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 returns.

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 performance.

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 periods?

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 performance.

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 you.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Basics

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