How to Choose the Best Mutual Funds

NEW YORK (MainStreet)—Choosing the best mutual funds to help maximize your portfolio returns can be a daunting task.

To ensure that your fund beats the stock market's returns, financial advisors recommend that investors research the following seven issues to obtain the best returns: examining the expense ratio, sales load, turnover ratio, underlying securities, share classes, portfolio manager and prospectus can give you a better chance to maximize your investment and lower your risks.

The expense ratio is a key factor in choosing your mutual fund. This is the fee charged by investment companies to pay portfolio managers for their research and analysis.

Investors should look for expense ratios to be in the 1.2% to 1.4% range, said John McDonough, president and CEO of the Studemont Group, based in The Woodlands, Tex. For an indexed or passive fund, the ratio should range between 0.2% to 0.5%, and investors should look for one that is 0.3% to 0.4%. If you choose an extremely actively managed fund, the expense ratio is likely to be closer to 2%.

"Investors look at the performance of the mutual fund for the past one to ten years and year to date," he said. "They are chasing returns. The lack of investor knowledge can be a drag on performance."

However, when investors focus only on the expense ratio, they could miss 1% to 3% on returns, said Scott Sonnier, president and chief investment officer of Financial Management Services of America, which is based in Lafayette, La.

"This is an important factor when you are researching comparable funds or asset classes and if the returns are equal," he said. "This will give an investor a better performance over the life of the fund."

Sales loads are commissions charged by financial advisors and stock brokers for their recommendation. The fee is paid by the mutual fund company but passed onto the investor. The three main types are front loads, back loads and level load and are commonly referred to as "class A, B and C" shares.

"The sales load is the commission received by the selling advisor," said Sonnier. "It is upfront and generally 4% to 5% of the money invested is taken right off the top. You have a net value that you have to try to make up."

There are many mutual funds that do not charge a sales load. You can purchase the no-load funds directly from companies such as Vanguard or Fidelity.

The most common type of sales load is the front load or "class A" shares. For instance, if you choose to invest $10,000 into a mutual fund with a 4% sales load, then it reduces your initial investment to $9,600.

The least expensive option is to chose the front load fund, said McDonough. He advises investors to hold them an average of seven to ten years.

Back loads or "class B shares" charge investors when they sell the mutual fund. Some of them charge every time you invest more money into the fund or have higher expense ratios, he said.

Level loads or "class C" shares charge a maximum 1% sales charge annually, compared to the "class A and B" shares which charge a one-time fee.

"The class B and C shares are just ridiculous," said McDonough. '"The cheapest way is to go is with no-load fund."

Investors often forget about the turnover ratio, which can play an important role in the overall return of the fund. The turnover ratio is calculated by how often every stock, bond or security is sold. Investors should look for ratios that are under 50%, he said.

One major factor investors tend to overlook is examining the underlying securities of the fund or what stocks, bonds and other securities are owned. The underlying securities determine whether your portfolio is diversified and can make a difference when you own several mutual funds.

This is crucial when you own company stock and in your portfolio and your contributions are matched, he said.

"This can result in overlap and you are not as diversified as you think," said McDonough.

Investors can often take advantage of the different share classes within the same mutual fund. With a higher initial investment such as $10,000 compared to $3,000, you can pay lower expenses.

"Share classes are important to hit a breaking point," he said. "That changes your total return."

Investors can start with a basic fund and then move up over a period of time, said Sonnier.

"You could be losing or leaving thousands of dollars on the table and by not moving up in asset class."

Portfolio managers are an important consideration, because their choices are "indicative of future performance," said McDonough.

The length of the tenure is important, because if you are looking at the returns for the past ten years and the manager has only been with the fund for 18 months, then that return does not demonstrate the manager's record, he said.

"Our big focus is to look for good quality managers that are now battle tested," said Sonnier. "We focus on returns and good managers. We look at fees, but it's not our driving focus. Our priority is to look for funds that perform at or are better than indexes."

Before you purchase a mutual fund, read over the lengthy prospectus, because it delineates the investment strategy, fees and other details.

"It provides a wealth of knowledge," he said. "It provides you with questions to ask. The more informed you are as an investor, the better you are able to see the good, quality investments and stay away from the bad ones."

Investors should examine their mutual funds once a year to make sure they are still achieving their goals, Sonnier recommends.

"Make sure the asset you bought is what you originally bought," he said. "You're leaving massive amounts of money on the table by owning an underperforming mutual fund."

--Written by Ellen Chang

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