How to choose mutual funds
Daniel Jimenez • Bankrate.com

It seems like everyone is catching mutual fund fever these days. All those funds claim to offer low risks and good returns on your investment. But they can't all be telling the truth, can they? Of course not. Choosing the wrong fund can leave you feeling more anxious than a prisoner the day before a conjugal visit.

Funds can be loaded with fees

The good news is that learning how to choose the right funds doesn't have to be complicated. You don't even need to have big bucks in order to get started investing. Gene Walden, author of The Top 100 Mutual Funds, states that you'll need about $500 to $2,500, depending on which funds you buy. Once you've made your initial investment, you can then add as little as $50 per contribution, according to Walden.

As a beginning investor, your first step should be to understand the basics of mutual funds. There are two kinds of mutual funds for you to consider -- load funds and no-load funds. Load funds are those that charge a sales commission. However, that doesn't mean those funds will necessarily bring you a higher return than no-load funds.

If load funds don't guarantee a higher return, then why do people buy them? The reason is because some investors think a stockbroker's advice is sometimes worth the added expense. Also, no-load funds aren't always the bargain they seem. Those funds can still carry management fees (12b-1 fees) or advertising expenses even if they don't charge a commission. Still, experts don't always agree over the value of paying commissions.

"I advise people never to buy a load fund because there's always an equivalent no-load fund out there," says Paul Farrell, mutual funds editor for CBSmarketwatch.com. "Why put up 5 percent of your money upfront? There are some load funds that do better than the competition. However, if you look at their earnings after taxes then they're not performing as well as they originally seemed. Stockbrokers will tell you that those expenses will even out after a five-year period. The problem with that logic is that many people are getting out of a fund after two to three years."

"If your broker gives you the recommendation, pay the fee happily," argues Walden. "But if you do your own research, then you should probably be biased toward no-loads."

Five keys to picking a fund

If you're an enthusiastic investor, you'll be glad to hear that some professionals have written entire books about how to choose a fund. I'm not that ambitious, so I'll just provide some simple guidelines to get you on the right path.

1. Set investments goals. Ideally, mutual funds are geared toward long-term investors. However, market returns have been so good in the past few years that investors have been pulling their money out much sooner than normal. Keep in mind that your financial goals are going to vary widely depending on your age. Having time on your side means that you can afford to be more aggressive with your investments -- since you have more time to recover from an unexpected loss.

2. Learn the signs of a well-managed fund. You're not going to have trouble finding out details about any fund, so you need to know what to concentrate on rather than risk information overload. Walden recommends that investors focus on a fund's performance, management and consistency.
   
   "I want funds that rank near the top of the list in terms of five-year returns; then I want to be sure the fund manager has been there several years, and I want a fund that is consistent year to year relative to the overall market," says Walden.

3. Understand the risks. In general, mutual funds are not considered to be too risky because they invest in dozens or even hundreds of stocks. Still, be careful to read the part of the fund's prospectus that talks about risk. Farrell, author of "The Winning Portfolio," warns that you shouldn't be fooled into thinking you can't lose any money on these investments.
   
   "There are a lot of funds that haven't done well even with the strong market," he says. "Small cap funds have lost 10 to 20 percent of their portfolio value recently. Funds involved in emerging countries have also done poorly. ... The American Heritage fund was the No. 1 performing fund two years ago, before it became heavily invested in a failed drug. ... The fund went from $100 million in holdings to about $3 million."

4. Study your resources. All funds have toll-free telephone numbers, so you can call them to get information and ask questions. Companies will also send you a free prospectus that explains the principal strategies, objectives, risks, performance and fees associated with a fund. In the past, these documents have been as easy to read as a set of encyclopedias. However, funds now offer a simplified "fund profile" that covers the highlights in three to six pages. The financial news media and companies like Morningstar, a popular mutual fund rating and data firm, are also great resources.

5. Dump what doesn't work. Farrell suggests that investors carry no more than eight to 10 funds in their investment portfolio at any time. You don't need to panic if some of your funds aren't kicking tail, but it's still a wise idea to reevaluate your portfolio every three to six months.

"There will usually be one to three funds in that group that are subpar performers," says Farrell. "If they are below the middle of their peer group for four consecutive quarters, then investigate the reasons why, and make the necessary changes."

Following these steps won't guarantee you a spectacular return on your investment, but you'll be much less likely to end up losing your investment. Here's one final piece of advice: Don't underestimate the value of diversification by putting all your money into one single fund. People who put all their eggs in one basket may come home to find someone's been making scrambled eggs in their kitchen.

-- Posted: July 2, 1999