Mutual Funds
Build Your Own Future
Follow these eight golden rules to package your mutual fund portfolio.
By Steven Goldberg, Contributing Columnist
From Kiplinger's Personal Finance magazine, May 2005
Follow these eight golden rules to package your mutual fund portfolio.
Compare apples to apples
To judge the quality of a bicycle, would you compare it with a motorcycle? You could, but it wouldn't make much sense. So it goes with mutual funds. There's no point comparing a bond fund with a stock fund, or a fund that invests in foreign stocks with one that buys domestic stocks, or a fund that invests in long-term municipal bonds with one that invests in short-term Treasury notes. It's best to assess funds by looking at similar rivals.
Judging funds against their peers will help you avoid the trap that many investors fell into during the late 1990s. The vast majority of top performers then were funds that focused on large growth companies. Many people looked only at performance and loaded up on different funds investing in the same kinds of stocks, a move that often led to big losses over the next three years. By comparing funds with similar funds, you're more likely to end up with a diversified portfolio.
Learn about style
To compare funds properly, you have to know how to categorize them. That's easy to do with bond funds. You can differentiate bonds by type (corporate, municipal, government, mortgage and foreign), credit quality and maturity.
With stock funds, it's not quite so simple. Some funds focus on larger firms, while others concentrate on small or midsize companies. Still others invest in companies of all sizes. Then there's a fund's approach to stock selection. Some funds invest in stocks that sell at low prices relative to company profits or other key measures. Other funds prefer to focus on firms that deliver above-average profit growth. Still other funds practice a blend of value and growth philosophies.
You can get a feel for a fund's style by reading its prospectus and shareholder reports, and by examining its holdings. Or just visit a Web site, such as Kiplinger.com's Fund Finder or Morningstar.com, that lists a fund's style.
Know the manager
It's the performance record that captures your attention, but it's flesh-and-blood human beings that make a fund tick. So rather than focus on a fund's record per se, it's important to study the performance of a fund's manager or managers. In particular, you want to examine the manager's record over at least the previous five years, and preferably ten.
Obviously, you want a manager with an outstanding long-term record in comparison with that of similar funds. But consistent performance versus similar funds matters, too. So does volatility, a proxy for risk. Great returns may not be acceptable if the risks are too great.
Because the manager is crucial, you must make sure that a fund's current pilot is responsible for its record. If the manager behind the results is gone, a fund's record may not be meaningful.
Mind your costs
With fund investing, you do not necessarily get what you pay for. If you pick funds on your own, you should always invest in no-load funds. There is no sense putting yourself in the investment hole by paying a commission (in the form of front-end charges for Class A shares or high ongoing 12b-1 fees for B and C shares) for fund-picking advice that you don't need.
Don't neglect operating expenses, either. In the short run -- a year, maybe even two or three -- operating fees don't matter all that much. In any given year, you'll find plenty of high-expense funds among the winners. But over longer periods of time, the low-cost funds dominate the lists of top performers. There are some superb high-cost funds, but they are exceptions. In general, you should avoid domestic stock funds with annual expense ratios of more than 1.5% or so and foreign stock funds with yearly expenses of more than 1.5%. Limit most of your bond funds to those with expense ratios of less than 1%.