5 Tips for Evaluating Mutual Funds

Investors have more than 7,000 options.

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Roger Wohlner
There are more than 7,000 funds from which to choose spanning a variety of asset classes and investment styles. How do you decide which funds are right for you? Here are five tips for evaluating a mutual fund:

Understand the fund's objectives and investment style. Look beyond the fund's name and its Morningstar style box. Research the fund. Look at what types of stocks or bonds the fund actually holds. Understand the restrictions on the fund manager. Some funds stay true to their investment style, while others have more latitude in where they can invest. Do you understand what the fund does? Under what economic conditions will the fund most likely be successful? In the case of a fund of funds, such as a target-date fund, you need to take the additional step of reviewing the underlying holdings and understanding the fund's asset allocation.

[See top-rated funds by category ranked by U.S. News Score.]

Review fund expenses. Smaller is better here. All mutual funds and exchange-traded funds have an expense ratio. These are expenses the fund incurs for trading stocks and bonds, salaries and overhead, and profit. The returns earned by fund shareholders are net of any fund expenses. In many instances index funds have outperformed the majority of their actively-managed peers. If you are paying for active management, understand what you are buying and why this fund is worth the extra expense. While you don't write a check for the fund's expenses, make no mistake—these are real costs of investing and these expenses are a drag on your returns. Even a seemingly small difference in expenses between two funds can add up over the course of 10 to 20 years of holding the fund.

Look behind the numbers. A fund may boast a stellar track record, but the manager who compiled much of that track record may have moved on. This is especially important with an actively-managed fund. In fact, if you are investing in an actively-managed fund, you are investing in the expertise of the fund manager.

Does the underlying benchmark make sense? This is especially important when evaluating an index mutual fund or ETF. With the popularity of passive investing, fund and ETF providers are pumping out new products based on a variety of underlying indexes. Make sure that you understand the index or benchmark the product is based upon and that investing in this fund makes sense for you.

[See 5 Common 401(k) Pitfalls.]

Size matters. Bigger isn't always better here, but neither is smaller. Asset bloat can be a big problem for some funds. This is especially true for funds investing in small- and mid-cap stocks. If these types of funds become too large, they will have difficulty finding enough new investment ideas. Well-managed fund companies will close funds that become too large. This shows concern for existing shareholders. This also limits the fund's profits because expenses are generally based on asset size. If a fund sponsor continues to allow a fund to grow unchecked, often the fund is forced to invest outside of its stated objective. For example, a small-cap fund may invest in mid-cap stocks in order to put new money to work. Ultimately, if asset growth continues unchecked that solid small-cap fund may morph into a mid-cap or even a large-cap fund. The manager may do a great job with small caps, but their expertise in the large-cap realm may be limited. On the other hand, a fund might build a great track record with a low asset base, but once the money starts to pour in (money often chases performance) the mangers may not be able to replicate their prior success with a larger asset base.

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Choosing a mutual fund is more than looking at a top funds list in one of the popular financial magazines. Beyond determining if the fund is a good or bad investment, the ultimate decision on whether to invest in any mutual fund should be made based on where the investment fits in terms of your overall financial plan and your investment strategy. This list is not all inclusive, please feel free to add your comments and thoughts regarding how to pick a good mutual fund or ETF.

Roger Wohlner, CFP® is a fee-only financial adviser at Asset Strategy Consultants where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. He recently cofounded Retirement Fiduciary Advisors to provide direct investment and retirement planning advice to 401(k) plan participants. Follow Roger on Twitter and LinkedIn.