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Personal Finance

Hal's Hints for Selecting a Mutual Fund

By Hal Ratner
401k Forum Mutual Fund Analyst

Your 401(k) plan is set up, and you're trying to choose a mutual fund from the list of six, eight, ten, or more that your plan sponsor handed you. Where do you begin? Well, there's always the "close your eyes and point" approach, but while that might save time now it certainly won't guarantee you the best return on your money. Neither will asking your colleagues for advice on "hot" mutual funds. (There's no such thing, as you'll read later.) If you really want to make the most of your 401(k) investment, you'll need to put on your detective's hat and trench coat for a few minutes and do some investigating.

We asked our Sherlock Holmes of mutual funds, Hal Ratner (Director of Mutual Fund Analysis), to come up with some tips on choosing a mutual fund. Here's his report...

With any purchase, your most important first step is to figure out exactly what you need. Before buying a mutual fund, you need to ask yourself the following questions:

  • What is my investment goal - capital appreciation, or income, or both?
  • What other investments do I currently have?

    These are important questions, because they will help illustrate what kind of mutual fund will balance out your investment portfolio (your collection of investments).

    Mutual funds can be roughly divided into three categories - stock (or equity) funds, bond funds, and money market funds. If you are a younger investor saving for retirement (with a longer investment "time horizon"), you will probably want to emphasize capital appreciation by investing in stocks. Investors who are closer to retirement would probably want to reduce the volatility associated with stocks and move to more stable, but lower return, bond or money market funds.

    Consider the following examples. Joe has 40 years until he retires, yet his only investment is a money market fund. Joe would do well to make his next purchase a stock fund in order to boost his return and help his savings keep up with inflation. Jane, on the other hand, is planning to retire next year and has her entire investment in Fly-By-Night Micro Cap Growth. She would be well advised to move her money into a short-term bond fund with more predictable - albeit lower - return potential.

    If you decide that an equity fund is what you need, you have more sleuthing to do. You need to be sure that what you're planning to buy is actually what you think it is. (Funds can, and sometimes do, move off-track from their stated goals.) An important thing to remember is never to be afraid to pick up the phone and call the fund company to ask about any of the following issues.

  • You gotta have style. Ask the company whether the fund's management sticks to a specific style (capitalization and valuation range). When people talk about a fund's "style" they aren't referring to the sartorial elegance of the fund manager. They are talking about what kinds of companies the fund invests in. You need to decide whether you want to take the higher risk of investing in, say, small companies with a large potential for growth (which could give you higher returns) or whether you prefer large, established companies which are valued more highly to begin with. (Small-cap growth vs. large-cap value). Once you've figured this out, you need to choose a fund with the style that's right for you.

  • Consistency matters. Ask the company what, if anything, would cause the management to move the fund out of the stated capitalization and valuation range. You need to find out whether the fund is expected to maintain its style because you are going to choose your fund, or funds, to complement your other investments. If you choose a mid-cap value and it starts behaving more like a small-cap growth, this will throw your overall portfolio off-balance.

    Enough of the pep talk; now you're ready for Hal's Hints!

    1) Diversify your investment pie. Given the vast number of funds that can be bought at relatively modest amounts ($50-1,000), most investors can buy into a number of funds, each devoted to a specific style of investing. This is something you might want to consider because diversifying your investment will give you the highest probability of reaching your goals.

    2) When you're hot, you're hot - unless you're a mutual fund. Don't think in terms of picking a "hot" fund, because a fund can't become hot in the sense that a stock can. For a stock, "hot" can become a self-fulfilling prophecy as a flood of buyers raises its price. A flood of buyers will not increase the price of mutual fund shares, but will just cause the fund to issue more shares. Remember, you're buying into an investment pool, you're not buying an asset. What causes a stock mutual fund to increase in value (or decline) is the combined performance of what's in the pool.

    3) Learn from history. Examine the style history of funds you are thinking about buying. A good way to do this is to look up the Morningstar and Value Line Mutual Fund surveys on the Internet (www.morningstar.com and www.valueline.com). You also need to find out how long the fund manager has been in charge. If you're looking at a fund that has performed well and is expected to maintain its style, you'll want to know whether the current manager is responsible for the results. While this is no guarantee that the fund won't change its style, it is unlikely that a manager who has been with the fund for a while will change. Again, this information is readily available from Morningstar and Value Line as well as the fund companies. Additionally, look at how well the fund has performed. Performance isn't everything, and it tends to get too much attention, but it is important.

    4) Measure up. Check how well the fund has done against a benchmark (one of those stock indexes you see in the newspaper). In most cases, it is best to use a well-known style-oriented benchmark such as the S&P Barra Value Index (at www.barra.com), and not a particular "fund style group," which is an index of mutual funds and not of individual stocks. The problem with style groups is that they are skewed downward by statistical impurities, high fees, and mediocre fund managers. Actively managed funds cost you more to invest in than index funds do, so you should see if the manager is earning his or her keep. Many managers measure their own performance against stock indexes. However, you should be aware that some managers, particularly of bond funds, measure themselves against inappropriate benchmarks that are nearly impossible NOT to beat.

    5) Consider investing in an index. You should also remember that you can invest in indexes through index funds. It is important to note, however, that not all indexes currently exist in fund form, so you may need to go with an actively managed fund to get the exposure you need.

    Elementary, my dear Watson. You've done your investigating, now how do you reach a conclusion? In sum, it is fair to say that any fund that has beaten, or at least equaled, its benchmark over a 3, 5, or 10-year period has performed very well and is worthy of further consideration. Keep in mind, too, that it is rare for funds to consistently beat their benchmarks, and that a shortfall of up to 75 basis points (three-quarters of one percent) would probably be acceptable.

    Investing isn't a pure science, and sometimes you've just got to listen to your instincts.

    The information provided here does not constitute any tax, investment or legal advice. Securities prices are subject to fluctuation and past performance is no guarantee of future results.

  • The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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