Five-Step Guide To Picking A Mutual Fund Investment

I include below five factors that I consider when evaluating a mutual fund offering that are a little bit different than the standard/conventional advice that is repeated ad nauseam on the topic:

#1. Pay attention to the manager rather than the fund when calculating performance history. Most people rely on a fund’s performance history when reviewing the 3, 5, and 10 year history for a mutual fund. But you should care about the specific person. For the past five years, it’s not that there has been something magical about “center fielder for the Los Angeles Angels.” Instead, Mike Trout is the magic player, and he happens to be center field. People fall into the trap of following the track record of the fund name rather than the manager. It is the manager who selects the stocks, and that is the track record you should study.

#2. Examine the fund for “style drift.” In other words, you should perform a check-up to see if the stated objectives of the fund correspond to the actual holdings. If a fund advertises itself as a deep value fund, does it help high-flyers like Amazon, Facebook, and Netflix? This isn’t necessarily a bad thing, as T. Rowe Price’s New Horizons fund has the stated objective of investing in small-cap stocks yet continued to hold Wal-Mart as it grew rapidly in the 1980s. That decision to make an exception benefitted PRNHX fundholders very well. But the point is to examine whether what a fund says it will do is the same as what it actually does, and then decide whether any incongruence is acceptable.

#3. Pay attention to the practical constraints. Check to see whether there are minimum investments for entry in the fund (typical minimums are $2,500, $3,000, $5,000, or $10,000 or $100 to $250 monthly investments until you reach that amount). See if there are any other fundholder benefits, such as the right of accumulation, systematic withdrawal opportunities, or exchange privileges.

#4. Look for a low turnover rate. I prefer mutual funds that have a turnover rate of 20% or lower. This means that each stock in the fund is held for an average period of five years. That implies that investment decisions are driven by fundamentals and the management team is looking for earnings growth to provide most of your returns. Some funds have turnover ratios as high as 70% or 80%. Not only does this mean that you may be subject to significant short-term capital gains taxes and other transaction costs, but it also means that a lot of stocks are only being hold for months with the average holding period just being 15 months. Those types of funds rely almost entirely on stock-market speculation.

#5. Determine whether the expense ratio is reasonable. If you want to own emerging bonds that are actively managed, you should be prepared to pay 1.5% each year fees. Same thing for emerging market small-cap funds. Those types of funds require a lot of sophistication and generally require large institutions to access the exchanges of dozens of countries, so you should be prepared to pay up. On the other end, U.S. bonds are easy to access and you should be wary of fees over 0.5%. Usually, I demand an excellent track record from an individual manager before I’d even consider purchasing a mutual fund that charges a higher rate than the average of similar funds.