Selecting the Best Mutual Funds

Updated on January 21, 2020
Earl Noah Bernsby profile image

I have a BA in Natural Sciences and Mathematics and am currently working towards a Certificate of Finance from TESU. (Only 3 credits to go!)

The best mutual funds are easy to spot if you know what to look for — they’re a lot like the lead runners in a marathon! (Photo credits are located at the end of this article.)
The best mutual funds are easy to spot if you know what to look for — they’re a lot like the lead runners in a marathon! (Photo credits are located at the end of this article.)

Selecting the Best Mutual Funds

Hello again! Welcome to part three of this tutorial.

In Section I. Mutual Fund Investing for Beginners, we discussed the makeup of mutual funds, how they work, and why you should care. In Section II. Different Varieties of Mutual Funds, we talked about the most popular types of mutual funds that are available to investors (i.e., stock funds, bond funds, hybrid funds and money market funds), touched on the importance of selecting mutual funds from reputable companies, and I even waxed philosophical about the dissimilarities between fund managers and Henry VIII! Now, in Section III. Selecting the Best Mutual Funds, it’s time to learn how to separate the best from the rest. We’re going to be discussing some solid and easily measurable criteria to help you assess whether or not a fund is worth your time and money.

Specifically, there are several important factors to take into consideration when choosing mutual funds. These considerations include fund performance over time, the actual experience level of the fund manager, the reputation of the fund’s parent company, and several components of — arguably — the single greatest determinant: the total “cost” of the fund. This does not simply mean the share price, but rather all of the costs associated with purchasing and maintaining your mutual fund shares. The best funds minimize these associated costs as much as possible, and there is no exception to this rule — no matter what commission driven brokers and network contracted talking heads may say to the contrary! I list some highly respected funds by company in Section VII. that will give you an idea of what to look out for in terms of a fund’s reputation and performance, but we’ll focus on assessing the total cost of a fund in this section.

You will want to look at three types of costs associated with purchasing and maintaining a mutual fund, before deciding whether or not to add it to your portfolio. These are the price-to-earnings (P/E) ratio, sales loads and the total fund operating expenses. Let’s discuss each one in detail:

P/E Ratio

The price-to-earnings (P/E) ratio is what you will look at to determine whether or not a mutual fund currently has a share price that is undervalued, is evenly priced, or is overvalued in relation to the market. For individual stocks, it is the ratio between a fund’s price per share and earnings per share. For mutual funds, the P/E ratio is generally the weighted average of all of the P/E ratios for the securities that the fund is invested in.

Now, don’t worry: you do not need to understand all of the calculations that go into determining a mutual fund’s P/E ratio in order to make use of this figure! Many free online market tracking websites provide detailed information, including P/E ratios, for most mutual funds. For instance, Google Finance and MSN Money are great resources for researching this kind of info.

Just remember a simple rule-of-thumb: if a fund’s P/E ratio is much greater than 15, then it’s share price is overvalued in relation to the Market. This could be because the fund is currently investing in riskier, high-growth businesses in order to rapidly increase profits. There’s nothing wrong with this strategy, per se, but the trade-off is that rapidly increasing profits can rapidly turn into losses if the Market takes a
turn for the worse. Moreover, such aggressive funds tend to rack up higher trading costs, which can also eat into profits (more on this a bit later).

Personally, I tend to think that buying mutual fund shares that are overvalued is wasteful, and may be likened to getting overcharged by an unscrupulous mechanic for work done on your automobile. Furthermore — as discussed in the previous section — many aggressive growth funds also happen to be “actively traded” funds, and very few of these consistently outperform solid index funds that focus on
comparable industries. There are some exceptions to this rule, and if you are planning on letting your money grow for an extended period of time (i.e., longer than five years) then the effects of higher P/E ratios are less pronounced.

On the other hand, if a fund’s P/E ratio is much lower than 15, then the share price is undervalued, and there may be an opportunity to purchase more shares at a discount. Finally, a P/E ratio which sits squarely at 15 implies that a mutual fund is being sold at a price that is equal to its actual “market worth.”1

Remember! To reap the benefits of stock market growth over time, it is necessary to reinvest profits made by dividends and capital gains into purchasing more shares of the fund. In this way, investor’s are able to maximize their earnings from compounded interest. (The return tables in this tutorial all assume that dividends and capital gains have been entirely reinvested — throughout ownership of the fund — for the time periods considered.)

Mutual Funds Make Money for Shareholders in Three Ways

Appreciation- Increased fund share price over time

Dividends- Profits paid to the fund from ownership securities that are dispersed among shareholders

Capital Gains- Profits earned when fund managers sell fund holdings (e.g., stocks, bonds, commodities) for more than they paid for them

Sales Loads

I’m going to make this simple —

When you encounter a mutual fund that carries with it any type of sales load, run (don’t walk) away from that fund! Sales loads are completely unnecessary, are designed to bilk investors out of their hard earned money, hurt returns and are easily avoided by choosing among the many no-load (N-L) mutual funds available.

There are several varieties of sales loads that investors should be on the lookout for. The first are front-end loads, which are deducted from a person’s initial investment when buying fund shares, in order to pay brokers who sell the security. Essentially, these charges are a “finders fee,” and are paid as thanks (out of the investor’s — not the mutual fund company’s — pocket) to brokers for bringing business to a particular fund. They typically range from four to eight percent of the principal investment.

Similarly, back-end loads are fees that are taken out of the investor’s wallet to pay brokers a commission when fund shares are sold. Some funds attempt to use deceptive language when advertising, in order to trick investors into buying shares of a fund with loads, by classifying the shares into different “categories”. For example, Mutual Fund X will tell you that if you buy shares of variety A rather than shares of variety B, and then hold those shares for a pre-determined amount of time, you will be exempt from sales loads when you decide to sell the shares.

But, don’t buy it (literally)! Funds that attempt to mislead you using these kinds of tactics will invariably charge investors more through higher operating expenses (covered below), miscellaneous fees or some other such nonsense. Once an unscrupulous broker or mutual fund management team decides to hustle money away from investors using unnecessary fees, you can be sure they will find a way to get that money, regardless of the type of shares bought and how long they are
held.

Buying into mutual funds with sales loads is like being victimized by a pickpocket!
Buying into mutual funds with sales loads is like being victimized by a pickpocket!

On that note, perhaps the most offensive fee charged by some mutual funds is known as the 12b-1 fee. This ambiguously named fee basically amounts to money being taken from unassuming fund shareholders in order to pay for “advertising costs”. Thankfully, the overall upward trend of personal investor education in recent years has shined a light on this dirty little fee, and many people now know to stay away from the funds that charge it. With any luck, mutual fund companies will simply discontinue the fee in years to come. Still, if you encounter a fund that is still levying the infamous 12b-1 on its beleaguered shareholders, you may safely deduce that the fund is not worth your time.

Similar to the P/E ratio, information about a fund’s fee schedule may be found through its information page on free financial websites, as well as in the fund’s prospectus.

Load Vs. No-Load Funds

The sad truth is that the majority of mutual funds with sales loads get outperformed by no-load mutual funds!

Total Fund Operating Expenses

Mutual funds, like any business, have operating expenses. Fund managers and research assistants draw a salary, rent and utilities at the fund’s office building must be paid, food and water — I suppose — must be provided for the interns, etc. Generally speaking, businesses that minimize expenses and maximize profits are better positioned to enjoy success than businesses that do not. This is also true for mutual funds.

As such, a good stock fund will charge shareholders an annual expense rate of around 1%. The very best will only deduct a fraction of a percent! Bond funds can get away with charging slightly less than stock funds — about .5%/yr. is reasonable — in total operating expenses, due in part to the lower turnover rate in a typical bond fund’s holdings as compared to a typical stock fund. Money market fund expense ratios really have no business getting much higher than .333%, and if you find one that greatly exceeds this generous estimate, politely (or impolitely — it’s your call) decline to buy shares in the fund. As with P/E ratios and fee schedules, total fund operating expenses (sometimes called expense ratios) for a fund may
be found on free financial websites and the fund’s prospectus.

Bull Vs. Bear Markets

A Bull Market is associated with increased (investor) confidence and overall investing, in anticipation of market share price increases. A Bear Market indicates a general decline in the stock market, and share prices over time (at least 20% over two months). It is a period of pessimism and investment anxiety.

In a Nutshell...

Keep Costs Down

Distinguishing between good and bad mutual funds means knowing how to analyze the fee schedule for any fund you may be interested in. Specifically, keep an eye on P/E ratios, whether or not the fund comes attached with sales loads and total fund
operating expenses. (Check out Table 4 below to get an idea of how high fees impacts the ability of your principal to earn over time.)

Only Consider Respectable Mutual Fund Providers

Also, remember that reputation is important! When choosing a mutual fund provider, keep in mind that companies like The Vanguard Group and Fidelity are some of the most respected and time-tested providers of funds in the business. Start-up companies with names like Bob’s Fly-by-Night Mutual Funds probably
shouldn’t inspire the same level of confidence. (I list some established mutual fund companies in Section VI. of this series, as well as some of the top mutual funds in the country in Section VII.)

TABLE 4: Comparison of a $10,000 investment, 10% annual compounded return, across two funds with different fee schedules

FEE SCHEDULE
FUND A
FUND B
Combined Sales Loads (4% of Principal)
$400
N/A
12b-1 Fee
1.0%
N/A
Total Fund Operating Expenses
2.0%
.17%
Total Return (1 yr):
$10,272.00
$10,981.30
Total Return (5 yrs):
$13,464.50
$15,981.03
Total Return (10 yrs):
$18,884.65
$25,539.35
A 3% annual fee on your investment, combined with a $400 sales charge may not seem like much out of ten grand, but — as you can see — it really adds up! *I’ll explain the formula for compounded interest calculations in Section IV.
Nearly there — Soon you’ll be navigating the ins and outs of mutual fund investing like a pro!
Nearly there — Soon you’ll be navigating the ins and outs of mutual fund investing like a pro!

References

1. P/e ratio [Internet]. Alexandria, VA: The Motley Fool; [cited 2013 Oct 4]. Available from: http://wiki.fool.com/P/e_ratio

Photo Credits

1. Participants near the end of the 26-mile course at the 29th annual Marine Corps Marathon, in Washington, D.C. Source: Journalist 1st Class Monica Darby, Public Domain (i.e., This photo is a U.S. Government work and is not subject to copyright: learn more.), via Wikimedia Commons. 31 Oct 2004. Available from: http://commons.wikimedia.org/wiki/File:USMC_Marathon.jpg

2. ‘Pickpocket Macro.’ Source: Steven Depolo, CC-BY 2.0, via Flickr. 2010 May 24 [cited 2014 Feb 28]. Available from: http://www.flickr.com/photos/stevendepolo/4637904620/

3. ‘The corner of Wall St. and Broadway, showing the limestone facade of One Wall Street in the background.’ Source: Fletcher6, CC-BY-SA-3.0, via Wikimedia Commons. 2008 Sep 13. Available from: http://commons.wikimedia.org/wiki/File:Wall_Street_%26_Broadway.JPG

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

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