How to Invest in Mutual Funds

By Markets Fool.com

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The best mutual funds to invest in are those that fit your investment objectives without charging high fees. When choosing funds, you should look for:

  1. Funds that meet your objectives.
  2. No-load funds.
  3. Low expense ratio -- companies like Vanguard and Fidelity offer some extremely cheap funds.
  4. Good Morningstar and/or Lipper ratings.
  5. Strong performance history.

Decide what you want to invest in

There are mutual funds that invest in all types of stocks, bonds, CDs, commodities, and more, so the first step is to decide what you want to invest in. And there are two main types of mutual funds to choose:

  • Passively managed funds track a certain index, such as the S&P 500 or the Russell 2000. These simply invest in all of the companies in an index, and don't require too-much effort on the part of the fund's managers. Because of this, these funds tend to come with relatively low fees.
  • Actively managed funds have a manager who chooses its investments, and decides when to buy and sell. Because the main goal of actively managed stock funds is to beat the market, and because of the additional effort required, actively managed funds usually have higher fees than passively managed ones.

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Lower costs = more money in your pocket

When looking for mutual funds, I automatically narrow my search to "no load" mutual funds -- which means that the fund doesn't come with a sales charge or commission. In most cases, your brokerage will clearly differentiate no-load mutual funds.

The most-important number you should look at when comparing mutual funds is known as the expense ratio. This tells you the total ongoing cost of investing in the fund on a yearly basis as a percentage of your assets.

For example, an expense ratio of 1% tells you that, if your investment is worth $10,000, you'll pay $100 in various fees. If you're interested, here's a thorough discussion of what makes up an expense ratio;but for most investors, it's sufficient to know that a lower expense ratio means a "cheaper" fund.

You may see two different expense ratios listed for a particular fund: gross expense ratio, and net expense ratio. Net expense ratio can be lower, as it includes any discounts or temporary reductions in fees. The gross expense ratio is the permanent amount, and is the primary number to pay attention to.

Small differences in expense ratios can have a big impact

It's important to emphasize that seemingly small differences in expense ratios can make a big difference over long time periods. As a simplified example, let's compare two hypothetical mutual funds, both of which track the same index. The only major difference between them is that the first charges an expense ratio of 0.75%, while the second charges a cheaper 0.5%.

If you invest $10,000 in each fund, and the underlying index produces average annualized returns of 8% per year before expenses, after 30 years, the first investment will be worth $81,643. Your investment in the cheaper second fund would grow to $87,550. If you ask me, a difference of more than $5,900 is well worth the effort of shopping around for a cheaper option.

This isn't to say that a fund with a lower expense ratio is automatically better than a more-expensive one in all cases. For passively managed funds, comparing expense ratios can be a highly effective practice. However, with actively managed funds, a higher -- but still reasonable -- expense ratio can be justified by a strong track record of market-beating performance.

What those fund ratings mean

Two of the most-frequently used ways of rating mutual funds are the Morningstar and Lipper ratings. Morningstar ratings use a five-star system to rate funds, and take into account the fund's past performance, the manager's skill level, risk- and cost-adjusted returns, and consistency of performance. Five stars is best, and only 10% of the funds evaluated get the coveted rating. Regarding the rest, 22.5% get four stars, the middle 35% get three stars, the next 22.5% get two stars, and the bottom 10% get one star.

Lipper uses five criteria: consistency, preservation of capital, expense ratios, total return, and tax efficiency. With this information, the funds in a given category are broken down into quintiles -- in other words, 20% get the highest rating, 20% get the next highest, and so on.

Both ratings are calculated over different time periods -- three-year, five-year, and 10-year periods, respectively. These can be useful in your research; just remember that these ratings are based on past performance, and are not necessarily a guarantee of future results.

Past performance doesn't guarantee future results, but...

Just because a mutual fund has performed well in the past doesn't necessarily mean it will do the same in the future. In fact, mutual funds tell you this themselves -- it's generally written right near the historic returns section on each fund's prospectus.

However, that doesn't mean you should ignore that section, especially when it comes to actively managed funds -- those that don't simply track a specific index. Consistently strong fund performance over the years is one sign of good management, and a smart strategy. It's also important to look at a fund's performance during tough economic times.

After all, if you look at a fund's performance over the past five years, take the information with a grain of salt. The S&P 500's total return was 83% during that time, and it's not difficult to make money in markets like that. Instead, it's a good idea to also take a look at how the fund did during, say, 2008, in order to get an idea of how the fund's investments hold up in bad markets.

The bottom line on mutual funds

Shopping for mutual funds can certainly be intimidating -- after all, there are literally thousands to choose from. However, by determining your investment objectives, considering highly rated funds, comparing expense ratios, and evaluating past performance, you can narrow down the selection, and find mutual funds that are right for you.

The article How to Invest in Mutual Funds originally appeared on Fool.com.

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