A 4-Step Checklist to Evaluate Any Mutual Fund
It's intimidating to stare at the list of mutual funds offered in your employer's 401(k) plan and wonder which ones you should trust with your retirement savings. When you open an IRA through a broker or mutual fund company you are faced with a seemingly endless list of investment options. How do you decide?
As an early investor, I made a common investment mistake. I based my investing decisions on the past performance of the funds. I have a vivid memory of looking at mutual funds in my 401(k) and choosing the funds with the highest 5-year return.
Relying on the past performance of a mutual fund as a selection criterion is a surefire way to short change a retirement portfolio. After all, the past performance of any investment is no guarantee of future performance. There must be a better way, and indeed there is.
This simple four-step checklist gives investors the information they need to make a reasonable investment decision:
1. Start with a plan. An investment plan, sometimes referred to as an asset allocation plan, is the foundation of sound investing. These plans do not have to be complicated. A three-fund portfolio, for example, is comprised of just three types of investments: U.S. bonds, U.S. stocks and foreign stocks. Other asset allocation plans involve more asset classes, such as real estate investment trusts, emerging markets and small U.S. companies. The key is to have an investment plan before selecting mutual funds.
With a plan in hand, an investor can then narrow down the search for funds that are consistent with the plan. For example, an investor looking for a mutual fund focused on U.S. companies can immediately eliminate from consideration bond funds and foreign funds.
2. Management style. The second investment selection step is determining the management style of the mutual fund. There are actively managed funds and passively managed index funds. Actively managed funds look to beat the market by selectively choosing stocks or bonds that the fund manager believes will outperform the market. In contrast, index funds don't try to beat the market, but simply aim to track the market.
For most investors, index funds are ideal because they typically have low costs and usually capture the typical returns of the market. When you invest in actively managed funds you are trusting the expertise of a fund manager, and most actively managed funds underperform the market over the long term. Even Warren Buffett recommends the low cost index fund approach to investing.
3. Cost. Investing costs are often ignored. One study involving students from Harvard and Wharton showed that many investors pick higher cost mutual funds, even when they are identical to lower cost options. But investing costs have a huge negative impact on returns, especially over the long term.
Index funds generally have significantly lower expense ratios. While many actively managed funds charge 1 percent a year or more, many index funds cost just 0.2 percent or less. In addition, because index funds are simply tracking the market, they tend to have significantly fewer trades each year. This lower turnover of assets reduces transaction costs and taxes.
4. Taxes. The final consideration is the type of account that will hold the mutual fund. The goal is to place tax efficient investments in taxable accounts, while placing high tax investments in tax-advantaged retirement accounts such as a 401(k) or IRA.
Investments suitable for retirement accounts include bond funds and REITs. Both of these investments tend to generate significant taxable income each year. By placing these investments in tax-advantaged retirement accounts, the tax consequences can be deferred until distributions are taken in retirement.
Rob Berger is the founder of the personal finance blog the Dough Roller.
