3 Critical Points to Consider When Selecting a Mutual Fund

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Many investors want to put their money to work in the stock market but are afraid to invest in individual stocks directly. Instead of going through the hassle of picking the companies themselves, they choose, or are forced to, invest through a mutual fund.

Mutual funds offer investors instant diversification and a professional money manager to make investment choices, a combination that many find comforting. However,not all funds are created equally, and just because investing in a mutual fund is easier than investing in individual stocks doesn't mean they don't require some homework of their own.

We asked our team of Motley Fool contributors to offer up their best advice that investors need to keep in mind before they put their money to work in a mutual fund. Here's what they said.

Brian Stoffel (check those fees): If you're more of a hands-off type of investor, I would suggest investing in ETFs instead of mutual funds. Historically speaking, the evidence is clear that the vast majority of mutual funds underperform the market, and do so while charging higher fees.

But if you insist on investing in mutual funds, checking the fees associated with the funds is crucial. While paying 1.5% of your assets every year might sound like a pittance, it makes an enormous difference over time. Consider the couple that has $500,000 in mutual funds and pays this fee -- not only do they lose $7,500 per year, but they also lose all of the growth that they'd have had if they didn't have to pay the fees.

When looking at a mutual fund prospectus, there are several key numbers to focus on. The first is any front-end or back-end load. These are fees you pay when you put money into a fund or take it out. If at all possible, avoid funds with these fees whenever you can.

The second key number is the fund's expense ratio. Generally, this tells you how much you'll pay every year to have your money in this fund. The lower the number (hopefully under 0.75%), the better.

The final area to watch is the fund's turnover ratio. In essence, this tells you how much of the fund's portfolio has been replaced within a given year. A fund with a lower number (say, 20%) will have lower trading and transaction costs than one with a higher number (over 100%, for instance). The fees associated with these costs don't show up in the expense ratio, but they are important to consider.

Selena Maranjian (turnover ratio): A key factor to examine when you're considering various mutual funds for your portfolio is their turnover ratio, which reflects how much buying and selling the fund managers have been doing in the fund over the past year.

It will typically look like a percentage rate, with a turnover ratio of 100% meaning that there was enough trading activity in the fund to replace all its holdings over the course of 12 months. (That doesn't mean it did so, of course. It may be hanging on to some holdings for years, and trading in and out of others frequently.)

It might not seem like a turnover ratio should matter much, but it does. For one thing, a low ratio, such as 10% or 25%, suggests that a fund's managers don't trade very often and are thus more committed to their holdings, presumably having a lot of confidence in them. A steep ratio, such as 150% or 200%, can reflect managers looking for the next hot investment and not sticking with any investment very long.

There's more. Just as frequent trading in your own personal investment account will rack up a lot of trading commission fees, high turnover ratios result in a lot of transaction fees for funds. Those fees ultimately cost you, the investor, in the form of lower returns. High turnover ratios will also make it likely that many of the fund's gains from buying low and selling high are short-term ones, from assets held a year or less. Such gains are taxable at your ordinary income tax rate, which is likely to be 25% or 28% and can even approach 40%. Long-term gains, meanwhile, which are more likely in funds with low turnover ratios, will usually be taxed at 15% for most folks.

Funds with high turnover ratios can perform well for you, but it's still good to favor lower ratios.

Brian Feroldi (management tenure): One of the most common ways investors go about choosing which mutual fund to invest in is by looking solely at the funds' past performance. It's natural to look over all of the fund choices, find the one with the highest historic returns, and put all of your money in the fund with the best history.

While there are somedrawbacks to using this methodology, there are worse ways to go about choosing a fund, so if this describes how you choose your mutual fund, it's critical to find out the manager in charge of the fund during its years of outperformance. You can visit Morningstar, type the fund name, and see who the current manager is and when that person took over. If the manager has been running the fund for five years or more and the returns have been solid, that's a good sign that the manager knows what he or she is doing. However, if the manager has been in charge for just a year or two, you can't credit that person with any type of long-term performance, and it might be best to look for another fund.

The article 3 Critical Points to Consider When Selecting a Mutual Fund originally appeared on Fool.com.

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